When analysts and pundits start talking about a bubble, most investors shrug it off as the usual market sensationalism.

 

#-ad_banner-#When a member of the Federal Reserve Board starts talking about a bubble, you may want to sit up and take notice. And when it is a bubble in the world’s most liquid investment, which serves as a benchmark for pricing in the $67 trillion global market for bonds, you may even want to start thinking about worst-case scenarios.

 

In fact, things have gotten so far out of whack that volatility in this “safe-haven” investment is now higher than volatility for stocks in the S&P 500.

 

Is This The Single-Biggest Threat To The Market?
The market for U.S. government debt tops $12.5 trillion, the most liquid of any investment and the benchmark for all other bond rates. The market for treasuries serves as a quick pricing mechanism for  other bonds and is known as the safe-haven investment in times of volatility.

 

But something has changed in the market for U.S. government debt, and the consequences could shock global markets. What’s worse, no one is talking about it.

 

From my viewpoint, it might be the shock that sends us into the next financial collapse.  

 

Dealers Step Away
To understand my concerns, you need to know how the government bond market functions. Historically, bond trading desks at the major Wall Street firms provide the capital and activity to keep these markets in a liquid state.

 

In recent months, the Federal Reserve has been reducing its own monthly purchases. At the same time, financial regulations have made bond dealers less willing to facilitate trades and hold treasury bonds themselves.

 

JP Morgan Chase & Co., one of the 22 primary dealers that trade in treasuries, estimates that the amount of 10-year notes available to buy or sell has dropped more than 70% over the last year. Primary dealers have reduced their U.S. debt holdings more than 80% to $24.5 billion from the peak levels seen in October 2013.

 

The drop in liquidity has led to fits of high volatility. The yield on the 10-year Treasury plummeted as much as 15% on October 15, 2014, the biggest fluctuation in 25 years.

 

No discernible news could account for the trading. The volatility was such a shock that the New York Fed met the next day to figure out what happened, but thus far has not made a public statement.

 

Prices for the iShares 20+ Year Treasury Bond (NYSE: TLT) have reflected the increased volatility. Annualized volatility of daily price swings in the shares averaged just 10% in the first eight months of 2014.  Over the last month, annualized volatility was 18.7%, representing even greater volatility than shares of the SPDR S&P 500 (NYSE: SPY), which showed a  17.5% reading over the same period.

 

 

The yield on the 10-year is at 1.80%, just off the 1.46% low in 2012. The current bond rally is partly due to foreign buying, as investors escape even lower rates elsewhere in the developed world. While rates will likely stay low in Europe and Japan for the rest of the year, there is little reason for rates to be so low in the United States.

 

Of course, when our interest rates move higher, bond prices will slump. Might that lead to a stampede out of bonds and repercussions for the global financial system?

 

Protecting Yourself From Bond Armageddon
While the futures market for treasuries isn’t pricing in an increase in rates until December, the Fed has the potential to surprise investors with an earlier hike. The unemployment rate is below the Fed’s previous 6% target, and the U.S. economy is one of the most robust in the developed world. Speaking to Bloomberg last month, Fed President James Bullard said  that rates could increase as soon as mid-year. He also sees the potential for a bubble in government debt.

 

Were that bubble to burst, we could be looking at another global financial crisis. Higher rates in the United States could push the rates of other bonds higher, resulting in a kind of economic restraint for anyone needing to borrow. Even if slower global growth causes the Federal Reserve to hold off on any rate moves, increased volatility in the treasuries market is adding a layer of uncertainty and could make 2015 a difficult year for investors.

 

The increased volatility has not yet hit prices for U.S. government bonds, but it could exacerbate the drop in prices when rates begin to rise. The iShares 20+ Year Treasury Bond Fund has surged 27% over the last year and 16% in just three months.

 

If prices on government bonds start to swing wildly, investors may decide to seek the safety and liquidity in other assets. Investors may want buy put options on the major market indexes, or sell shares (or ETFs) short to protect against the potential for market turmoil.

 

While the SPDR Gold Shares (NYSE: GLD) has rebounded 12% off of the November low, it could still see upside as gold renews its appeal as a safe haven investment. Gold is the next most likely choice as a global safe haven and should also benefit this year from the increase in global central bank stimulus.

 

The European Central Bank is planning on injecting more than $1.2 trillion into the regional economy through monetary policy. And the Bank of Japan has announced that it would increase its own balance sheet by 15% of GDP annually, about $735 billion, to meet its inflation target.

 

Moreover, competitive devaluation of currencies has increased this year, which is good news for gold prices as people look for a more stable store of value.

 

Risks To Consider: Treasuries are still a liquid market and the reduced liquidity may not lead to a full-blown crisis. Investors may want to use this trade idea for portfolio hedging, instead of speculation of a collapse.

 

Action To Take –> A breakdown in liquidity for Treasuries has already brought volatility and could turn into something worse for the market. Hedge your portfolio with other safe-haven assets or by shorting the Treasury Bond ETF.

 

No one knows when the next market downturn will be, but that doesn’t mean investors should get scared out of the markets. StreetAuthority’s premium newsletter, Total Yield, uses two criteria to find the world’s safest companies. Not only has the strategy returned an average of 15% per year since 1982, but it’s outperformed the S&P during the “dot-com” bubble and the 2008 financial collapse too. To learn more about his “Total Yield” investing strategy, click here.