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.)

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

Related Articles
  1. Economics

    India: Why it Might Pay to Be Bullish Right Now

    Many investors are bullish on India for all the right reasons. Does it present an investing opportunity?
  2. Stock Analysis

    Analyzing Altria's Return on Equity (ROE) (MO)

    Learn about Altria Group's return on equity (ROE) and analyze net profit margin, asset turnover and financial leverage to determine what is causing its high ROE.
  3. Investing Basics

    Building My Portfolio with BlackRock ETFs and Mutual Funds (ITOT, IXUS)

    Find out how to construct the ideal investment portfolio utilizing BlackRock's tools, resources and its popular low-cost exchange-traded funds (ETFs).
  4. Investing News

    Icahn's Bet on Cheniere Energy: Should You Follow?

    Investing legend Carl Icahn continues to lose money on Cheniere Energy, but he's increasing his stake. Should you follow his lead?
  5. Stock Analysis

    Analyzing Google's Return on Equity (ROE) (GOOGL)

    Learn about Alphabet's return on equity. How has its ROE changed over time, how does it compare to its peers and what factors are driving ROE for the company?
  6. Investing News

    Is Buffett's Bet on Oil Right for You? (XOM, PSX)

    Oil stocks are getting trounced, but Warren Buffett still likes one of them. Should you follow the leader?
  7. Investing

    3 Things About International Investing and Currency

    As world monetary policy continues to diverge rocking bottom on interest rates while the Fed raises them, expect currencies to continue their bumpy ride.
  8. Investing News

    Chipotle Served with Criminal Probe

    Chipotle's beat muted expectations and got a clear bill from the CDC, but it now appears that an investigation into its E.coli breakout has expanded.
  9. Stock Analysis

    Analyzing Sprint Corp's Return on Equity (ROE) (S)

    Learn about Sprint's return on equity. Find out why its ROE is negative and how asset turnover and financial leverage impact ROE relative to Sprint's peers.
  10. Stock Analysis

    Why Alphabet is the Best of the 'FANGs' for 2016

    Alphabet just impressed the street, but is it the best FANG stock?
  1. Should mutual funds be subject to more regulation?

    Mutual funds, when compared to other types of pooled investments such as hedge funds, have very strict regulations. In fact, ... Read Full Answer >>
  2. Do ETFs pay capital gains?

    Exchange-traded funds (ETFs) can generate capital gains that are transferred to shareholders, typically once a year, triggering ... Read Full Answer >>
  3. How do real estate hedge funds work?

    A hedge fund is a type of investment vehicle and business structure that aggregates capital from multiple investors and invests ... Read Full Answer >>
  4. Are Vanguard ETFs commission-free?

    While some Vanguard exchange-traded funds (ETFs) are available commission-free from third-party brokers, a large portion ... Read Full Answer >>
  5. Do Vanguard ETFs require a minimum investment?

    Vanguard completely waives any U.S. dollar minimum amounts to buy its exchange-traded funds (ETFs), and the minimum ETF investment ... Read Full Answer >>
  6. Can mutual fund expense ratios be negative?

    Mutual fund expense ratios cannot be negative. An expense ratio is the sum total of all fees charged by an asset management ... Read Full Answer >>
Trading Center