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Tickers in this Article: TBT, PST, TBF, UUP
When bubbles form in the stock market, it is often caused by a trend that morphs into euphoria. The trend has been to move money out of stocks and into government bonds over the last eight months. As a matter of fact, through the first six months of 2010, inflows into bond funds totaled a massive $559 billion compared to outflows of $232 billion from equity funds. The morphing from a trend to a bubble has begun. The question that looms is this: When will it burst, and how should investors prepare for the next great bubble?

IN PICTURES: Top 6 Uses For Bonds

Two weeks ago, the U.S. 30-Year Treasury Bond had its best week since May as the yield fell as low as 3.66%. The fears of a weaker U.S. economy in the months and years ahead has investors locking in at historically low interest rates in lieu of stocks.

Bond Owners Hurt

My question to the Treasury bulls is this: Why would you lock in at such low rates when our government continues to print money at an alarming pace with no end in sight to stop spending? In my opinion, the bigger concern should be inflation in the years to come, not deflation. And the buyers of Treasuries now will be paying for it later - twofold!

First, they will take a hit on the Treasury purchases as the bubble bursts. A 1% increase in the 30-year yield, from 3.66% to 4.66%, will result in an 18% LOSS in the Treasuries' value. A similar move in the 10-year yield will result in a 9% LOSS! The longer the bond is dated, the larger the risk investors take if their bet goes wrong.

Profiting From Falling Bond Prices

ETFs, which allow investors to profit from falling bond prices and rising yields, have become popular with bubble theorists like myself. Because everyone loves to take more risk than they should, the ProShares UltraShort 20+ Year Treasury ETF (NYSE: TBT) is the vehicle most use to make money on a treasury bubble. The ETF is leveraged two-to-one - the inverse of the long-dated treasury bonds. As bond prices fall and interest rates rise, TBT will increase in value and vice versa. The catch is that the daily moves it makes will be twice the underlying index, adding often-unwarranted risk.

Investors that do not need the added risk of a leveraged ETF can choose the ProShares Short 20+ Year Treasury ETF (NYSE: TBF). This ETF is identical to TBT except that it moves one-to-one with the bonds, without the built-in leverage. Both TBT and TBF concentrate on U.S. bonds with long maturities and, therefore, they will be the biggest movers in the event of a bubble bursting.

To lower the risk level slightly as well as the potential reward, investors can use the ProShares UltraShort 7-10 Treasury ETF (NYSE: PST), which moves inverse to the movement of intermediate-term U.S. bonds. When the bubble bursts, the move will not be as dramatic. However, if the trade goes against the investor, the losses will also be smaller.

Interest Rates And The Greenback

All things equal, a rise in interest rates in the U.S. will likely lead to an increase in the U.S. dollar's valuation. The higher interest rate will attract more foreign money and, therefore, push up the value of the greenback. To position themselves for a rise in the U.S. dollar, investors can purchase the PowerShares DB U.S. Dollar Index Bullish ETF (NYSE: UUP). The ETF follows the U.S. Dollar Index that tracks the value of the greenback versus a basket of foreign currencies. A rise in the U.S. dollar will increase UUP's per share value.

Timing Is Everything

The question as to whether the Treasury bubble will occur is not the big question on Wall Street. The question is, "When?" I may be a few weeks early or months early on my call, but the way things have been looking, I am willing to start preparing for a bubble sooner rather than later. (To learn more, check out Bond ETFs: A Viable Alternative.)

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