No Mister Bond Market, I Expect You To Die

Much has been made of the stock market tanking in the last 4 months, but much more attention needs to be paid to the bond market.

A disappointing 5-year Treasury note auction was a less obvious, but potentially more insidious, contributor to the market's malaise. The record $30 billion auction priced with a yield of 1.82% well above expectations and up from 1.54% at last month's five-year auction, Bloomberg reports.

Prices of Treasuries with maturities of two-years and longer fell sharply in reaction to the lackluster demand for the 5-year auction, which "may signal investors will have trouble absorbing the as-much-as $2.5 trillion in debt the U.S. is likely to issue this year to pay for a $1 trillion budget deficit and programs to spur the economy," Bloomberg says.

That sentence is notable for its understatement. If the government has to pay higher yields on debt sales, the various bailouts and stimulus packages will turn out to be even more expensive than currently contemplated. And don't be fooled into the "what's bad for bonds is good for stocks" mindset; a big reason the Fed stands ready to buy longer-term Treasuries is to help keep rates down, and their failure to be more specific about those plans yesterday also contributed to weakness in fixed-income today.

Foreign investors are beginning to ignore US Treasuries, especially long-term notes. This has the potential to bring down the economy much faster than a stock market crash would. America runs on China buying our debt...and China is no longer happy with that arrangement.

Then there's the scenario where the U.S. government is forced to pay extremely high interest rates - or is simply unable to sell Treasuries - because foreign buyers go on strike. We're a long way from that "sum of all fears" outcome, but comments from Chinese Premier Wen Jiabao at Davos critical of U.S. economic policy suggest it's getting closer - especially in the wake of Tim Geithner's "manipulation" comment.

I don't think we're very far from that "sum of all fears" moment. In fact, I think there's a very good chance that we'll see foreign buyers go on a strike of sorts sometime before the end of the year.

When that happens, the real economic pain will begin in this country. Foreign investors just aren't going to be able to afford US treasury debt any longer. That will imperil our ability to pay that money back, causing a self-fulfilling prophecy that leaves us all officially broke. What happens when the US government goes belly up? The printing presses go full tilt as a last resort, and the dollar disintegrates in value.

How fast and how brutal that process is will decide if America is just crippled as a world leader or a mortally wounded third world economy.