The risks for US yields may be to the upside, despite the frantic Fed easing.

In response to the momentous popping of the US credit bubble and ensuing credit crunch, investors have desperately snatched up US treasuries as the classic safe harbor hedge in times of trouble. But are US treasuries – especially at the long end of the curve — really a safe place to hide in the coming market cycle?

The apparent logic for the frantic government bond buying is this: the thing to fear most during the unwinding of a huge asset bubble is deflation, and riskless treasuries are the best protection against that eventuality. No doubt a large element of the rise in US treasuries has been knee-jerk hedging of risky bonds and exotic structured vehicles that have been pummeled in the credit crunch. The rally has been most impressive at the short end of the curve as the curve has steepened drastically. US 2-year notes have executed an incredible 300 basis point nosedive from over 5% in mid 2007 to less than 2% as of this writing. This swoon in rates means that the market is already pricing in a further 100 basis points or more of easing from the Fed, which has already slashed rates at a whiplash-inducing pace from 5.25% to 3.00% in the space of just over four months.

The long end of the curve has followed suit to a lesser, if still marked, degree, with the benchmark 30-year US T-Bond falling under 4.25% at its recent lowest levels. While traders may be excused for bidding up the shortest end of the curve (buying short treasuries that depress yields) owing to a Fed that is willing to pull out all stops to prevent a systemic meltdown to the financial system – we see a tremendous risk to the long end of the curve, where yields may already be reversing higher. Here is why we may see a potential V-shaped recovery in the US yields – especially at the long end of the curve — in the coming weeks and months:

1) Persistent Inflation. The risk that inflation continues higher even as economic malaise spreads. Everyone in the market is assuming that inflation will taper off as it did in the 1990-1 recession and 2000-1 “recession lite”. What if it doesn’t? This factor alone could generate an enormous move up at the long end of the curve.

2) Weak tax revenues. Besides the risk of inflation itself, the weak economy going forward will mean weak tax revenues for the US government, which would at the same time attempt to increase deficit spending to stem weakness in the economy. An oversupply of new debt may have a hard time finding buyers.

3) Slackening demand. There’s the risk that the world’s great export powers (China, Japan, etc..) lose some of their appetite for accumulating even more US debt than they already have, meaning that yields must go higher to attract buyers.

Chart of US 10-Year Note Yields

Note that US 10-year yields have been in a declining channel for the better part of 30 years. But must yields always fall? Last year, we saw an attempt to break the declining trend that failed, and many are betting on a further decline in yields — but we feel the risk is to the upside despite the very long term trend. The Fed knows that the US simply cannot afford deflation.

Shorter Term Chart – US 30-Year Yields

The furthest out on the curve 30-year yields are showing less willingness to fall lately, as the attempt below 4.25% was roundly rejected early this year, even as the Fed has further lowered rates and the yield curve has steepened. Note how the 55-day (red) and 200-day (blue) moving averages seem to be important levels for yields. The 30-year has crossed above the first of these.

In short, it appears that the only upside for the long end of US treasuries from current levels would be in a deflationary depression scenario — a la the Great Depression of the 1930’s. Ben Bernanke is one of the world’s foremost students of deflationary depressions, having studied the US Great Depression and the Japanese lost decade in great depth. He is famous for his “Fed dropping cash from helicopters” speech at the height of the stock market scare in 2002 when deflation fears were rampant, suggesting that the Fed can always prevent inflation by printing more money. Mr. Bernanke will not let a deflationary depression happen and will do everything in his power to stop it — that is why we saw the record setting slashing of interest rates recently (125 bps within 10 days) as Helicopter Ben is trying to swoop to the rescue. We need to beware the V-shaped potential of US rates going forward as Mr. Bernanke WILL succeed.