By Michael Pento

The similarities between the subprime mortgage crisis and that of the coming collapse of the U.S. bond market are uncanny. In fact, Mark Twain may have had the U.S. debt market and the previous debt-fueled real estate crisis in mind when he said that “History does not repeat itself–but it does rhyme.”

The housing and credit crisis first became evident to most in 2007 with the distress in the subprime mortgage market. The foundation for the housing bubble was low interest rates, which were provided by the Fed, and passed along to consumers via commercial banks and the shadow banking system. Those low “teaser rates” from the Fed compelled consumers to take on too much debt and for banks to become overleveraged. Excessive lending in the real estate sector of the economy caused home prices to skyrocket out of reach of most consumers. Home prices subsequently fell and the assets on banks’ balance sheets tumbled in value. The result was the biggest economic contraction since the Great Depression.

Similarly, rock bottom interest rates provided by the Fed and from foreign central banks recycling our trade deficit are misleading the government into believing it can take on a tremendous amount of debt by spending significantly more money than it collects in revenue. Those low rates have also duped the Treasury into believing it can sell a virtual unlimited amount of debt without ever incurring a substantial increase in debt service expense. Of course, this is not unlike homeowners who took on onerous mortgage payments, believing home prices would always increase.

And just like those homeowners who took on adjustable rate loans, our Treasury has set itself up for a bout with intractable mortgage rate resets. Interest rates are currently at historic lows, but instead of choosing to take advantage of those rates by locking them in for decades, the U.S. Treasury has chosen to follow the lead of subprime borrowers. The government should be taking on the equivalent of a thirty year fixed-rate mortgage by issuing only 30 year bonds. However, they have chosen the path of what amounts to a short term adjustable rate mortgage by moving their debt duration to the short end of the yield curve.

Today the Treasury has an average maturity on its debt of just about 5 years. Compare that with the U.K. which is about 14 years and even to Greece which is about 8 years in duration. That means the U.S. must roll over its debt much more frequently and is much more susceptible to rising rates. The only logical explanation for this practice is that the U.S. doesn’t feel it can issue long term debt and still afford to service its interest rate expenses.

Another similarity between the housing and bond market bubbles is that the housing market of circa 2006 and the U.S. bond market of today contain all three elements of a classic asset bubble; massive oversupply, an unsustainably high price level and over-ownership of the asset class in question. In the early part of the last decade, home builders began to increase construction volume to twice the intrinsic demand for home ownership. Home price to income ratios eventually reached unsustainable levels. And levels of home ownership reached a record high percentage of the population.

Likewise, the U.S. Treasury is dramatically increasing the supply of debt each year to fund our $1 trillion deficits. The public has plowed their savings into the U.S. debt market as commercial bank holdings of Treasuries have reached an all-time high. And bond prices have soared, pushing the yield on the 10 year note to 3.6%, which is less than half the average yield of 7.3% going back to 1969.

Therefore, all the elements of a bubble in the bond market are in place, just as they were for the real estate market in the middle of the last decade. And now, if we do not aggressively cut spending on the federal level, the bond market may be ready to enter a multi-decade bear market in prices. The trigger for this secular move higher in yields will be the resurgence of inflation and the overwhelming effect supply has on bond prices.

However, a temporary reprieve from significantly higher yields has been given courtesy of Europe. Investors are fleeing Greek debt and the Euro currency in favor of the U.S. dollar and our bond market. But this is a temporary phenomenon and in no way bails out America from its own fiscal transgressions. In just a few years our publically traded debt will reach nearly $15 trillion. If interest rates just rise to their historic averages, the interest on our debt (depending on the level of economic growth and tax receipts) will absorb anywhere from 30-50% of total Federal revenue. If we indeed reach that point, massive monetization of the debt may be deployed by the Fed in a vain effort to keep rates from spiraling out of control.

One last similarity between the two bubbles is that the prevailing consensus of not too long ago was that home prices could never decline on a national level. Today, we are being told that the U.S. dollar will always be the world’s reserve currency and that Treasuries will always be viewed as a safe haven by global investors. Remember how those in Washington and on Wall St. also assured investors that the subprime mortgage problem was well contained and would not bring down the housing market-much less the entire global financial system? Well, regardless of what those same people are saying now, these record low yields on U.S. Treasuries are unsustainable and cannot last given our massive $13 trillion national debt, $108 trillion in unfunded liabilities and the record-high $2.3 trillion Fed balance sheet.

Astute investors should prepare now for the likelihood of much higher interest rates in the not too distant future.

Michael Pento is the Senior Market Strategist for Delta Global Advisors

We recently observed the first anniversary of the most shocking and terrifying week in most of our financial lives: the economic cataclysm of September 15–19, 2008.

Even the greatest one-day stock market crash in history on October 19, 1987 did not shake us the way this Hell Week did, inasmuch as it was almost entirely contained in the equity market: the economy, the banking system, and the world at large, aided by a tsunami of liquidity from the Federal Reserve, rolled merrily along. The epicenter of the earthquake—at the corner of Broad and Wall Streets—turned out to be the whole earthquake.

And the terrorist atrocities of September 11, 2001, even as they forced us to confront a whole new global geopolitics—and our position in the world as the target of an unfathomable crypto-religious hatred—had, after the initial shock, no lasting economic effect.

But Hell Week 2008 shook the global financial system to its foundations. The previous week, the federal government had taken over the two government-sponsored mortgage enterprises Fannie Mae and Freddie Mac as they teetered on the edge of the abyss. On Monday, September 15, Lehman Brothers failed. It was (and remains) the largest corporate bankruptcy in American history, but on that day, this datum seemed almost beside the point. The issue was how much damage Lehman’s failure would do to financial institutions all over the world which were exposed to Lehman through complex derivatives—in the jargon, Lehman’s counterparty risk. No one seemed to be able to get a handle on this, and that uncertainty struck terror in the heart of the financial system. That same day, Merrill Lynch—one of the last great, independent investment banking and brokerage houses—was forced to merge with Bank of America in order to stave off its own imminent failure.

The next day, the government had to bail out one of the world’s largest insurance companies, AIG, whose counterparty risk threatened to be even greater than Lehman’s. And indeed, on that day—having written off its exposure to Lehman—the Reserve Primary Fund, a $62 billion money market fund, “broke the buck.” That is, its net asset value fell below a dollar a share. Suddenly, no one knew what three trillion dollars of nominal money market fund assets were really worth, and panic liquidation set in on a hitherto unimaginable scale.

And so the week went on, with the government desperately injecting unprecedented amounts of liquidity into the financial system, in an attempt to prevent the credit markets from going into anaphylactic shock. All in vain: by week’s end, it was becoming clear that the global market for credit was shutting down. And as it did, the world economy—to which credit functions as oxygen does to the human body—would fall off a cliff. Never in our lifetimes has economic activity in our country fallen so far so fast as it did in the fourth quarter of 2008 and the early months of 2009. Hell Week had been the detonator of a global thermonuclear financial implosion.

It is a minor irony of Hell Week that the stock market, as measured by the S&P 500, closed that Friday at its high for the week: 1255. The rally, such as it was, was propelled by the hope against hope that the government’s apparent willingness to intervene without limit—to do, in Fed Chairman Bernanke’s phrase, “whatever it takes”—would stem the tide. Reality would overtake us soon enough: driven relentlessly lower by massive home foreclosures, a cascade of bank failures, the bankruptcy of two of Detroit’s Big Three and soaring unemployment, the equity market would in the next six months decline by nearly half from its Hell Week close, to 676 on March 9. (And this, of course, was the continuation of an already significant bear market which had begun when the market topped out at 1565 in October 2007.)

It was the nearest thing we had ever seen to the end of the world. Investors fled equities in a wave of panic which has few if any antecedents in our lifetimes. As 2009 began, deposits in passbook savings accounts and money market funds (the latter now guaranteed, in desperation, by the government) were greater than the market capitalization of the entire U.S. stock market, as denominated in the Wilshire 5000 stock index. Think of it, dear reader: for months on end—on any given day—the holders of cash equivalents earning less than one percent per year could have reached out and bought the American stock market in its entirety by nightfall. Yet they did not. And indeed, why would they? It was the end of the world. Everyone said so.

As I write, a year almost to the day since the end of Hell Week, the S&P 500 stands at 1070—about fifteen percent below its close on the Friday, and less than six percent below the week’s low at 1134.

How can that be? Why, Hell Week was the beginning of the end of the world. Look what unfolded over the next six months: inarguably, the onset of the end of the world. Everyone said so.

Yet six months further on—the best six months in the American stock market since 1933, if anyone’s counting—we’re within a whisker of where we were in the middle of Hell Week. And will—sooner than later, if one may hazard a pure guess—surpass those levels. This eventuality will, when and if it happens, wipe out all the market’s “losses” since the morning of Lehman’s failure. Far more to the point of this essay, it will leave everyone who panicked out of the market during and after Hell Week—and who is still out—under water. Again: how can this be? What on earth can have happened?

What happened, dear reader, is that once again, seemingly against all reason and logic, the world did not end.

A detailed recitation of all the economic phenomena which have turned importantly positive—manufacturing (up eight months in a row), retail sales, productivity, the national savings rate, household net worth (the first uptick in two years), and even housing starts—is probably not necessary here. Indeed, even the last, lingering negative economic indicator, unemployment, seems to be in the process of topping out. The major banks have begun repaying their TARP money, and are recapitalizing. Merger and acquisition activity has restarted from a dead stop. And in a final irony, the Treasury just in the last few days quietly ended its guarantee program for money market funds, stating quite correctly that it was no longer necessary. We are by no means out of the economic woods—now, all that excess liquidity has to get mopped up before inflation ignites—but (a) we’ll cross that bridge when we come to it, and (b) that’s way beyond the scope of this essay.

One wishes simply to point out, here, that the world did not end—as indeed, historically, it has always failed to end in all the crises of yesteryear—and that everyone who predicated his portfolio on the end of the world has once again, at this writing, thrown snake-eyes. This is neither economic nor market commentary. Still less is it a prediction of the economy, nor of next year’s market. It is purely an inquiry into the tragedy of panic.

Even more seductive than the siren song of a fad near its top—the Internet in 1999, real estate in 2005, oil in the spring of 2008—is the hypnotic spell of catastrophism near a bottom. This is a psychological much more than it is an economic phenomenon, since it is well documented in the literature of behavioral finance that we fear loss far more acutely than we hope for gain. The peaceful and even blissful illusion of “the safety of cash”—bringing with it surcease from the pain of watching our investments lose value every day—becomes at such times well-nigh irresistible. And to justify giving in to the lure of cash, we latch on to whatever apocalyptic theory comes most readily to hand in the mainstream media.

And invariably—at least throughout history so far—we come bitterly to regret it.

This is, finally, the lesson of Hell Week one year on: that however horrific this particular turn of the cycle was, it was just that: a turn of the cycle. But that the cycle itself had not been repealed. And that if history was any guide—and it remains the only guide we have—however much the rubber band was stretched in one direction, even so would it snap back when released.

It was not necessary to know how or when the cycle would reassert itself, and in fact no one did, because no one consistently can. (And even if a lonely voice or two had spoken up for the imminence of the cyclical turn, the cacophony of catastrophism last winter would surely have drowned them out.) It was merely necessary to maintain one’s faith that the cycle would turn. But that faith was and is much more a temperamental than an intellectual quality. And one nurtures it not by studying the economy at any given moment, but by studying history all the time.

The great documentary filmmaker Ken Burns has said, “History is medicine. It has nothing whatever to do with the past. It has everything to do with the present.”

A word to the wise: next time—and you may be sure there will be a next time—just keep taking your medicine.

© 2009 Nick Murray. All rights reserved. Used by permission.