A T-Bond Bubble Waiting to Burst

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Remember when the Dow Jones industrial average touched 14,000 a year ago? When gold reached $1,000 per troy ounce in May, and Moscow's RTS market index was trading above 2,500? Or when a barrel of oil cost $147 in July?

When the bubble in the U.S. housing market deflated in mid-2007, a massive wave of money began sloshing around the world, quickly inflating and then bursting a series of speculative bubbles in various markets.

Now, it is up to the final bubble -- the U.S. government debt bubble. Treasury bond yields have been falling steadily over the past year and a half, as investors looked for safety amid collapsing markets and economic uncertainty: The yield on the 10-year Treasury bond fell from more than 5 percent to 3 percent. Falling yields mean that bond prices have skyrocketed; the price of the 30-year T-bond is at a record high.

But T-bonds may no longer offer the traditional safety on which investors have usually counted. On the contrary, bond prices may plunge just as spectacularly as house prices, commodity prices and stock prices have in recent months. What's remarkable, Russia may end up playing a key role in the deflation of the U.S. government debt market.

True, Russia has a small economy, accounting for no more than 3 percent of global gross domestic product, and its financial markets are no match for the world's financial hubs. It is a major player in only two areas -- commodities and natural resources. Nevertheless, Russia nearly dragged down the global financial system when it suffered a debt default in 1998, and it may do so again now.

Although the Central Bank's gold and foreign currency reserves have decreased from their August high of $600 billion, they are still the world's third-largest, at $484 billion. Over the past decade, the Russian government has been one of the world's most important buyers of dollar-denominated securities. According to U.S. Treasury Department data, Russia bought about $65 billion worth of T-bonds since the start of 2007, but sold about $5 billion in September alone.

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Overall, Central Bank reserves shrank by $122 billion by early November -- mainly to fund the bailout programs and to support the ruble. This suggests that the government sold even more Treasury securities over the past six weeks to come up with the cash.

Moreover, the holdings -- and sales -- of T-bonds by Russian official entities and private investors have been underestimated, since many Russian companies and wealthy individuals hold their assets in Luxembourg, the Caribbean and other offshore centers. Russia has been hit by the current financial crisis harder than most other emerging economies, which means that the liquidation of its U.S. Treasury holdings will continue, and may even accelerate in coming months.

This may be the start of a global avalanche, since other central banks have been drawing down their reserves as well, albeit by smaller amounts. Further down the road looms China's $586 billion fiscal stimulus package, which will be financed by the liquidation of U.S. Treasury securities that the country's government and central bank hold.

Even as world central banks stop buying U.S. T-bonds and start selling them, demand for funds in Washington is escalating. The federal budget deficit reached a record $237 billion in October alone. In fiscal year 2008, which began Oct. 1, it will widen to at least $1 trillion. Washington will need to raise $1.5 trillion in the current year, according to U.S. Treasury Secretary Henry Paulson. It is safe to assume that Paulson's estimate is a conservative one.

Driven by rising supply and falling demand, yields on U.S. government bonds may spike. This will cause interest payments, which currently measure some $450 billion per year, to skyrocket. The worst-case scenario would be if the United States finds that it can't borrow what it needs at any price -- the same situation many consumers and companies already face in the current credit crunch.

Unlike private borrowers, however, the government has a solution. It can simply print money to meet its financial obligations.

This is an old trick. The printing press is the last resort of any government that discovers it can no longer raise money from lenders or taxpayers. It was used by the German government after World War I and, more recently, by such debtor nations as Argentina and Brazil. Printing vast quantities of money inevitably produces higher inflation, but, on the other hand, inflation has the advantage of reducing the real value of debt and, in countries with a progressive taxation system, of boosting government revenues, since it pushes more taxpayers into higher income brackets.

Since the dollar is a reserve currency, the problem with printing dollars is that the subsequent inflation will be instantly transmitted abroad. At the start of this decade, for example, no nation could escape a liquidity bubble once the U.S. Federal Reserve began pumping dollars into the world financial system. If Washington starts printing extra dollars, foreign central banks will either be forced to revalue their currencies sharply against the greenback -- and thus worsen the already nasty recession at home -- or issue more domestic currency to match the depreciating dollar.

For now, most economic forecasters around the world still expect falling prices next year. Consumer prices in the United States fell by a dramatic 1 percent in October. But this will change quickly if the Treasury bubble bursts and the U.S. government is forced to start up the dollar printing presses.

Russia, as usual, has the most to fear from this turn of events. Russia has not been able to defeat inflation this decade, when inflationary pressures elsewhere in the world were benign, and its consumer prices continued to rise at double-digit rates for most of the period. The World Bank sees inflation increasing to as high as 14 percent next year.

The current crisis has shown that the negative developments in world financial market affect Russia sooner -- and harder -- than most other emerging economies. If the United States suffers a bout of high inflation, Russia -- and its long-suffering savers -- may face something similar to the hyperinflation the country experienced in the early 1990s.

Alexei Bayer, a native Muscovite, is a New York-based economist.