I think we're near a tipping point. The day to watch is June 30.
Months, even years later, we might all look back upon that day as when things started to change.
Put simply, this program amounts to the Federal Reserve borrowing money to buy Treasury bonds. The government is essentially selling Treasury bonds to itself. The result is more liquidity, lower interest rates, and higher prices on government debt.
If the fact that the Federal Reserve is borrowing billions to buy Treasuries seems a little fishy, you're not the only one who thinks so. I do too. And so does Bill Gross, one of the most famous and successful bond investors on the planet.
"The Treasury issues bonds and the Fed buys them. What could be simpler, and who's to worry? This Sammy Scheme as I've described it in recent Outlooks is as foolproof as Ponzi and Madoff until... until... well, until it isn't. Because like at the end of a typical chain letter, the legitimate corollary question is, 'Who will buy Treasuries when the Fed doesn't?'" Bill Gross, founder of PIMCO and the most famous bond investor in the world, wrote in his March Investment Outlook.
According to Gross, the Federal Reserve is buying an estimated 70% of all government bonds, making the Federal Reserve the largest single holder of Treasuries, just ahead of China.
So who is going to fill the gap when the Federal Reserve starts exiting the market?
Bill Gross has already made it clear he won't be stepping in to buy unless the yields on Treasuries rise.
And China won't be buying either. With about $1.2 trillion in U.S. Treasury holdings, China is already the largest foreign holder of U.S. debt. But going forward, China is unlikely to be a major buyer given its already enormous exposure and the currently low yields.
This points to one of two possibilities. Either the Federal Reserve will have to implement another round of quantitative easing (QE3), taking up the slack in the Treasury market... or yields will have to rise to attract more buyers.
Of course, that's not the only reason to think we're going to see higher yields. There are plenty more...
- Government spending is out of control. According to the U.S. Debt Clock, we owe $14.3 trillion, which is nearly $130,000 per taxpayer. Yet we are considered one of the safest borrowers in the world and can borrow at rates lower than just about anyone else? It doesn't make much sense.
- Standard & Poor's slashed its outlook on our "AAA" debt rating from "stable" to "negative." The ratings agency believes there's at least a 33% chance it will lower its rating on U.S. debt within the next two years.
Without a doubt, that's a signal to the market that U.S. Treasuries are riskier -- and the government should have to pay higher yields to compensate.
- Ten-year bonds were yielding less than 3%. When you factor in the cost of inflation, which was measured at 3.6% for all items based on the May 2011 Consumer Price Index (CPI), those paltry yields leave investors with a negative real rate of return each year.
How long will investors put their money in an investment that loses purchasing power? I think all the signs are pointing to higher yields.
Even literally dozens of America's biggest companies are doing everything they can right now to borrow every penny in preparation for higher interest rates.
In mid-May Johnson & Johnson (NYSE: JNJ) borrowed $3.75 billion in a bond offering -- the highest amount in the company's history. Texas Instruments (NYSE: TXN) raised debt for the first time in a decade. And Google (Nasdaq: GOOG), despite having more than $34 billion in cash and short-term investments on hand, sold bonds for the first time ever.
In the May 18 issue of The Wall Street Journal the chief financial officer of Texas Instruments, Kevin March, even said, "Rates are so low it's hard to see them going much lower, but it's easy to imagine them going higher."
Now, I don't think this move in Treasury yields happens overnight... but I do think the tipping point is June 30. That's when the Federal Reserve quits "QE2," turning off the flow of new cash into Treasuries.
This investment is designed to move UP in price when yields rise.
But what if rates don't rise? That's the beauty of buying right now. There's no guarantee rates are going higher. But interest rates are near an all-time low, so I think the risk/reward is firmly in our favor.
We won't get rich off this idea, but a solid 20-30% return isn't out of the question... especially with June 30 right around the corner.
If you're not convinced, I urge you to watch the webcast I just released yesterday, which details the effects we might see come June 30. You can view it here. Even if you don't take action like I am, I think it's important for you to know about possible consequences of the end of "QE2".
One more thing -- remember we're in uncharted waters here. No one can say for certain what's going to happen when the Fed stops putting new money into Treasuries.
Japan is really the only "case study" we know. It introduced quantitative easing in 2001, and ended the program in March 2006. Today, more than five years after the program ended, the Japanese Nikkeiis still more than 40% lower than it was when the program was over.