Government Debt Could Weigh Down Your Portfolio

U.S. Treasuries have been called one of the safest investments you can make. The idea that the U.S. government would default on its obligations used to be akin to a snowball’s chance in hell.

Now, some analysts aren’t so sure.

From Bloomberg:

[Bill] Gross [who runs the world's biggest bond fund at Pacific Investment Management Co.] said in an interview March 11 that he eliminated government-related debt from his Total Return Fund because investors aren’t being adequately compensated for the risk of quickening inflation.

He’s not alone. Bloomberg also reports that Warren Buffett has been advising against holding long-term fixed-dollar investments like Treasuries. He told investors at a conference in New Delhi, “If you ask me if the U.S. dollar is going to hold its purchasing power fully at the level of 2011, 5 years, 10 years or 20 years from now, I would tell you it will not.”

Indeed, in the first quarter of 2011, Treasuries showed a 0.1% loss… And that’s on top of the 2.7% loss in the last quarter of 2010.

And now, even the debt-guzzling Federal Reserve is warning of inflation.

Richmond Fed President Jeffery Lacker told CNBC on Friday that the Federal Reserve could raise rates before the end of the year. But will they stop buying up billions of dollars in government bonds? Not likely. Kind of a self-fulfilling prophecy, then, eh?

The Federal Reserve buys more government debt, which hammers dollar value, which causes inflation, which causes the Fed to raise rates.

CNBC reports that the bond markets could take the first hit if this happens.

Citing Rob Lutts, chief investment officer at Cabot Wealth Management, “For bond investors, they’re in a huge bubble. The valuations in bonds are just as extreme today as in 2000 for tech. The valuations on short-term Treasuries and even the 10-year is not rational in this environment.”

Here’s my take on it… Nobody wants to be the bad guy. Nobody wants to tighten the monetary supply because GDP will suffer.

I’d argue that GDP growth isn’t nearly as good as it seems with a falling dollar valuation.

Why not take the hit now, and get back to real growth?

They say desperate times call for desperate measures… Well, we’ve seen how desperate moves by the Federal Reserve have put us in an even tighter pinch than we really need to be. And these moves have effectively blinded the market to inflation concerns.

That’s why these analysts’ comments on the current bond market are so important. They’re like the canary in the coal mine, and a popping of the bond market bubble could mean a huge decline in the stock market as well.

I mean, we’re starting to see some irrational risk-taking again.

(Investing doesn’t have to be complicated. Sign up for Smart Investing Daily and let me and my fellow editor Jared Levy simplify the stock market for you with our easy-to-understand investment articles.)

The Wall Street Journal reported on Friday that subprime bonds are back, and that long-term investors are buying them up!

The ultra-safe, low interest rates the Federal Reserve has been issuing makes these investments look like a sweet deal, especially with the markets rallying. But if we understand that this rally is built with fake money, then those longer-term investments don’t look so shiny…

And here’s something interesting: The hedge funds are mopping up these loans. The bonds are yielding between 5% and 7%, and have doubled in price over the past two and a half years. They stand to make a hefty profit…

If everything works out well for our economy, and we keep growing, and we’re able to cut back on the amount of government debt we (and the rest of the world) are buying, then I’ll probably be eating my words.

But if not, then we’ll be heading into a high inflation era, and you’ll need to protect your portfolio.

The next three to six months will be really interesting. In mid-summer, the Federal Reserve will end its second round of quantitative easing, and we’ll either be talking about QE3 or raising interest rates.

Now’s the time to take a look at your portfolio. Are you holding government debt?

If so, you might want to balance that out a bit. According to Harry Browne’s Permanent Portfolio strategy, you should be holding long-term bonds in times of deflation. But in times of inflation, which we are surely edging toward no matter what the Fed decides, you want to be holding gold.

Gold, or another hard asset denominated in dollars… That could be platinum or silver, or even oil or agricultural commodities.

Just look at this chart comparing the U.S. Dollar Index to gold over the past six months:

View larger chart

The inverse correlation is pretty obvious at the mid-February mark. It’s even more pronounced in this chart comparing the U.S. Dollar Index to oil…

View larger chart

These two charts show just how powerful dollar-denominated hard assets can be when the value of the dollar falls.

It’s investments like these that will help you protect your portfolio.

What specifically should you be buying? It depends on your investment experience.

The most direct way to take advantage of these types of dollar-hedging investments is through futures or options on futures. If you have experience with these types of investments, than you can also play the short-term waves in both the dollar-based commodities and the U.S. Dollar Index itself.

(And if you’re super-savvy, you can take playing the U.S. Dollar Index to the next level by using futures and options in international currencies… Double the impact by choosing currencies from resource-rich countries, like we did in our collaboration with EverBank to create the Ultra Resource Basket CD.)

The next “purest” investments are commodity-based exchange-traded funds and notes (ETFs and ETNs). These ETFs and ETNs actually follow the price of their underlying commodity, be it oil, silver or gold. Many times, these ETFs and ETNs own the commodity itself, so the shares are backed in part by the specific commodity.

This is different than investing in ETFs that basket a number of commodity-based companies, like oil producers or gold miners.

These investments, along with investing in these companies individually, are another level away from the actual hedging power of dollar-based commodities. They have their worth, and can generate swift and significant gains, but they also have costs that factor into their share prices, like fuel and personnel.

But through any of these three hedging possibilities, you can find a bit of security for your portfolio.

Again, the next three to six months will be very important. Keep an ear to the ground when it comes to the Fed, but always look to their actions for their true beliefs about the economy.

And right now, the Fed has no plans to halt its QE2 debt-buying spree.

Editor’s Note: At this moment, a ruthless government conspiracy is cannibalizing American jobs… crushing hopes for an economic recovery… and setting up the single greatest profit opportunity of the last 83 years. Act now, and you could be $97,500 richer. Here are the details for this special investment report…

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