Despite the Federal Reserve’s aggressive moves to purchase or monetize billions of dollars in Treasury supply this year, prices continue to roll over. Treasury’s are in the midst of their worst year of performance since 1994 when the Fed began raising interest rates.

This time, the Fed is not hiking rates. Instead, it’s attempting to keep a lid on rising long-term rates by purchasing the mid to long-term yield curve in a bold attempt to influence important mortgage rates and other consumer loans. Thus far this effort is failing.

The yield on the benchmark ten-year T-bond has climbed from barely 2% at the end of December to 3.36% this morning. The 30-year T-bond has been the hardest hit this spring with yields soaring from about 3% in late December to 4.31%. Earlier this year, the Sovereign Society Portfolio initiated a trade betting against long-term Treasury bonds vis-à-vis an ETF; that position is up more than 20% since late March.



The Fed, of course, faces tremendous headwinds, possibly a gale force in its attempt to keep rates stable.

Treasury issuance this year is estimated to surpass $1.2 trillion dollars while possibly reaching $2 trillion in 2010. There’s just too much supply hitting the market and investors are demanding higher interest rates.

Making the Fed’s task even more daunting is the stunning recovery in capital markets since early March as investors dump Treasury bonds en masse to assume more risk in stocks, speculative bonds and foreign currencies. This event has put significant pressure on the entire U.S. yield curve, especially longer term rates, which the Fed cannot control.

As I mentioned yesterday, sharply higher mid to long-term interest rates might take the air out of this short-term economic recovery – largely financed by government spending. The rapid increase of longer term interest rates now poses serious risks to any recovery.

Though I’m certainly bearish on Treasury bonds, especially long-term T-bonds, I’m starting to consider short-term Treasury paper up to five years. This segment of the yield curve offers yields up to 2.16% and selling around $98, or a modest 2% discount to par. Six months ago prices were rich and yields barely 1.5%.

In a world that’s gone hog-crazy for risk following the worst crash since 1937, I find myself hunting for conservative investments that pay regular dividends or income. The big decline in Treasury bonds should be viewed as an opportunity to park some money ahead of the next shock later this summer or fall. In that event, yields will come crashing down again and T-bonds will rally.

A heavily leveraged economy that’s still in the process of unwinding credit and toxic securities now faces a serious threat from rapidly rising longer term interest rates. This is not a normal bear market. Sharply higher rates are now in the process of derailing this fragile bear market bounce.

Have a good weekend. See you on Monday.