Treasury Bonds: From Ultra-Safe to Battered and Bruised

Billed as risk-free, U.S. Treasury bonds are generally regarded as safe-haven assets. After all, the bonds have the full backing of the U.S. government. But investors this week may be waking up to an entirely different risk: the alarming drop in bond values and rising yields that brightening economic prospects can bring.

As recently as early November, the benchmark 10-year U.S. Treasury bill was scraping along at 2.48%, but now it's jumped back up to nearly 3.3%, with much of that rise coming in a few short days, especially since President Obama announced his tax cut compromise with Republican lawmakers.

That has investors scrambling for answers. Some point to the potentially deteriorating credit quality of the U.S. because of the increasing debts that the tax cuts imply. But that's off-target.

German bunds and Japanese government bonds have also come under pressure, even though both countries have balance sheets no less pristine now than when President Obama announced that he was willing to work with Republicans to extend tax cuts for all income levels in return for some concessions on unemployment benefits.

What Happened to the Double Dip?

Instead, falling Treasurys along with a strengthening dollar imply that markets are once again honing in the prospects for U.S. growth.

It wasn't long ago that hammered by the financial crisis, investors were ditching stocks and scrambling for shelter in supposedly safe Treasury bonds. Given their protracted grave outlook for the U.S. economy, a cacophony of bearish pundits told investors that even with such rock-bottom yields, Treasurys still made for a good deal.

Rising interest rates in anticipation of a recovery over the spring -- the payment investors demand for holding the note -- might have been a warning sign. But bears greeted what in hindsight seems like a normal, mid-recovery hiccup with cries that a double-dip was imminent and that the U.S. was on the cusp of Japan-like deflation. The yield on the 10-year Treasury sank to levels seen in the aftermath of the Lehman Brothers collapsed as investors braced for Armageddon.

But as signs mount that an economic recovery is gaining strength and that taxes will remain low, the bull market in paranoia may be coming to an abrupt end, as indicated by the surging yields on 10-year Treasurys since consensus on taxes appears to be in the making.

How to Hedge Exposure to Treasurys

Investors should note that the sell-off could be as irrationally violent as the pile into Treasurys was over the summer. Increasingly automated and momentum-driven markets can lurch from one extreme to the other.

But now, commentators are mulling ways to hedge exposure to the Treasury market.

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For example, the ProShares UltraShort 20+ ETF (TBT) also allows investors to make a directional bet against long-term Treasury prices. The fund tracks twice the inverse daily percentage change in long-dated Treasurys and has already rallied sharply over the last two days on heavy volume.

Like most ETFs, the TBT is oriented for trading rather than for a buy-and-hold strategy. But it does help investors offset declines in Treasury portfolios.

Of course, Treasurys could snap back, and safety continues to be attractive in the current environment. More macroeconomic gyrations emanating from Europe -- or bellicosity from North Korea -- along with headwinds for the U.S. economy could make government bonds more attractive.

But inflation anticipations on the back of a recovery are equally likely and could further hammer Treasurys. The widely held deflationary consensus that pushed yields to such absurdly low levels, however, will have trouble being taken as gospel again.