Then on Tuesday the market snapped up $25 billion in ten-year notes and yields fell. Sovereign debt? Big whoop! Whether it's the end of the year and investors feel safer in Treasuries, or some other reason, Tuesday's auction showed no signs of an impending "bond fire of the vanities." The bond bubble keeps getting bigger.

Today, though, the market gagged. In an effort to lock-in low rates for longer terms, the Treasury served up $16 billion in 30-year bonds. The market turned sour. Reuter's reports that demand for the 30-year was the weakest since May and that yields moved up as the weak auction triggered selling.

And then everyone seemed to lose their nerve. Stocks fell across the board. Gold set a new high at $1,123.40 in New York trading, before retreating. The weak 30-year auction has people thinking...what happens when Treasury supply overwhelms demand?

What will happen to bond prices then? To inflation? What should I do?

The rest of today's Daily Reckoning will be devoted to some constructive apocalysm. We may have left the impression yesterday that there was nothing but pain and heartache ahead for investors. But that doesn't have to be the case. But you have to start with the big picture. And that begins with the end of the bull market in bonds.

Check out the chart below from Ron Greiss at the www.thechartstore.com. Ron's chart shows long-term U.S. bond yields since 1941. Mostly this reflects the yield on 30-year bonds, although there were periods where 30-year issuance was discontinued. Either way, it shows a great cycle...which appears to be bottoming out.

What story does this chart tell? We reckon it shows you why the U.S. government (and so many banks and borrowers) are eager to sell as much debt now as possible. Rates are near historic lows. If and when they go up, it's going to make borrowing and servicing new debt even more expensive. Bond prices will fall and yields will rise again.

Now you could say that, according to the chart, there is room for another decade of low yields. The Fed, for example, could move to set rates further out on the yield-curve. It only sets rates right now for short-term debt. But the quantitative easing program has moved the Fed out to ten-year yields. It's done this to try and keep mortgage rates low, as mortgage-rates are keyed to U.S. ten-year yields.

But we reckon not even the Fed can keep yields low forever by supporting prices. It will have to wind down its programs eventually. For example, the U.S. government ran its largest October deficit ever last month, at $176 billion. Between demographics and existing debt, the Fed may not have the resources to support bond prices too.

Besides, you'd think markets would begin to tire of U.S. debt, given the lousy fiscal position of the American government. At least that's what we'd think. And if we were trading it, we'd look for put options on ETFs that track bond prices, or call options on ETFs that track bond yields. That would be the cheap trade.

The investment decision is to find assets that out run inflation as bond yields move up. Granted, this assumes there is going to be inflation, which is a whole other argument. But if you'll grant us the assumption, we'll continue with the strategy...of finding assets that beat inflation.

You don't have to look far. Gold...oil...iron ore...tangible assets are what you're after. Does this conflict a bit with our analysis yesterday that China's resource demand is more fragile than reported? Yes, it does. But it still pays to focus on those resources that will be in demand no matter how bad the global economy gets again. What do nation states really want to own? What can they not do without?

You know they can't do without oil. And you know more and more of them prefer to own at least some gold rather than rapidly devaluing foreign currencies. That leaves us where we began, buying oil and gold and selling U.S. sovereign debt. Production of the first two is hard to increase. Supply of the last one is growing.

"There is a strong case to be made that we are already at 'peak gold'," Barrick's Aaron Regent told London's The Daily Telegraph today. Regent was speaking at RBC's annual gold conference in London. "Production peaked around 2000 and it has been in decline ever since, and we forecast that decline to continue. It is increasingly difficult to find ore."

Gold exploration budgets are up. But with the exception of China, gold production from traditional stalwarts like South Africa and Australia has trended down. Alex Cowie at Diggers and Drillers recently wrote a report suggesting that the best Aussie gold stories are listed here in Australia but digging for gold in Africa, where they incur production costs in U.S. dollars and where there are more greenfield projects than recycled brownfield projects.

Frankly, we have no idea if gold production has peaked. Mine supply could grow this year for all we know. But finding and mining gold is not easy and it's not cheap. And even if the gold supply does grow, we'd take it to the bank that the global gold supply will not grow faster than global money supply.

And oil? Any scenario in which an economic collapse leads to falling GDP ought to mean lower demand for oil and lower oil prices. But the case for oil is not really about the demand side. You reckon that's bound to grow over time anyway, unless someone comes up with table top cold fusion. The real oil bull story is on the supply side.

Earlier this week the U.K.'s Guardian reported that, "The world is much closer to running out of oil than official estimates admit, according to a whistleblower at the International Energy Agency who claims it has been deliberately underplaying a looming shortage for fear of triggering panic buying."

" 'The IEA in 2005 was predicting oil supplies could rise as high as 120m barrels a day by 2030 although it was forced to reduce this gradually to 116m and then 105m last year,' said the IEA source, who was unwilling to be identified for fear of reprisals inside the industry. 'The 120m figure always was nonsense but even today's number is much higher than can be justified and the IEA knows this.'"

We remember writing about the IEA figure a few years ago. And we remember pointing out that producing 120 million barrels of oil per day would be a 44% increase on producing 83 million barrels per day. And you'd have to find that oil first. You'd have to explore, drill, and produce it. And you'd have to maintain existing production levels at the world's big elephant fields like Cantarell and Ghawar.

In point of fact, production at Cantarell has fallen by 25% since 2004. Energy expert Matthew Simmons says Mexico's days as an oil exporter will end in 18 to 36 months. This makes Mexico's government-which derives 40% of its revenues from oil sales-the most likely candidate for "next failed state."

By the way, if you think illegal immigration is problem in America now (and it is), imagine what would happen if the finances of the Mexican state imploded with a production catastrophe at Cantarell. The Obama administration would face another crisis, but this one right on its massive southern border.

Not everyone believes in Peak Oil. But it's not really a matter of faith. Either oil production is declining or it is not. It does not mean there isn't any oil left. In fact, technology has lengthened the life of productive fields. And technology has also made it possible to find and produce oil in increasingly hostile environments (deep water drilling, the Arctic, etc.)

Even rank and file petroleum geologists are mostly in agreement (and sometimes in disagreement with their corporate overlords) that Peak Oil is real and it's here now. But we make this point not to say that all is lost. It isn't. It's just the great changes in the world are afoot.

You have a secular bond bull that's long in the tooth. The post-war monetary system that supported the expansion of the fiscal welfare state through perpetual debt is failing. Energy, which has been getting cheaper and cheaper for years as we found more and more of it, may start becoming more expensive and harder to find.

That's going to make the world a slightly less friendly place. But for investors, there are heaps of opportunities. For example, right now Alex is looking at what the fallout from next month's Copenhagen summit is. It has opened the door to a great entry point for energy investments, but not necessarily oil. Fear not! Or fear a little. But prepare.

Dan Denning
for The Daily Reckoning Australia

• Attack of the Bond Yields
• Central Bankers Encourage Debt Booms That Become Debt Bombs
• U.S. Bond Prices Rose and Yields Fell
• Higher Oil Prices, the New Normal
• Consumer Price Inflation has Spooked Investors Everywhere

The most critical question an investor faces today is whether he wants to smash up on the rocks of deflation...or run aground on the hard place of inflation. Posed the question - inflation or deflation? - we have always answered 'yes.' We will have both. But it is gradually occurring to us that we will have both more abundantly than we realized. As Hugh reminded us: we know of no case where quantitative easing has actually worked. It seems to work only where it is applied to excess - where the results are catastrophic hyperinflation.

The feds are more incompetent than even we suspected. They are trying to cause mild inflation - say, 4%...maybe 6%...even 8%. But they aren't doing a very good job of it. Their efforts are too hesitant...they're too worried about what the anti-inflation hawks will say...and about what the bond vigilantes will do. "What if the Chinese dump their Treasuries?" Yikes, that is too awful to contemplate. "Better go easy on that quantitative easing."

The Chinese...unhampered by bond vigilantes [they are the bond vigilantes] or good sense...are increasing their own money supply three times faster than the United States.

Our Feds are trapped between the same rock and the same hard place as the rest of us. Either they run into the rocks of hyperinflation...or into the hard place of deflation. Just like Japan's central bankers and finance ministers. They COULD cause inflation...but the price of it is too high. So, they take baby steps...boosting the money supply too little to offset the natural deflation of a major correction.

Of course, this is what makes us fear hyperinflation too. There doesn't seem to be any safe channel between Sylla and Charybdis. If they are going to cause inflation...they have to really inflate the money supply. Not by 9% a year...but maybe by 900%. We don't know what it will take; neither do they. All we know is that what they are doing now is not working. Prices are falling, not rising. Bond prices are rising - indicating that the vigilantes don't think inflation is a problem. And the foreigners - notably, the Chinese - are still ADDING to their supplies of US Treasury debt.

So, dear reader, what should you do? Inflation could take much longer to arrive than most people think. A dull, sinking, dreary economy - like the weather in Ireland today - could be with us for years. The dollar could go up...gold could go down...for many moons.

Are you prepared to wait it out? We will leave you to think about that....

We're still troubled by Hugh's comments. The inflation narrative is "too easy to articulate," he says. Too many people see it coming.

"The market clearly is not worried about inflation right now," says colleague Chris Mayer. "That is the only way to explain 10-year Treasury yields of 3.30% as of last Friday. The deflationist view is the one that prevails. This view, which makes some compelling and elegant arguments, maintains that the credit losses far surpass the monetary and fiscal stimulus. All those trillions in destroyed debt, plus the yanking of credit from consumers and businesses, overwhelm new money creation."

Many years ago, we looked at the danger of a "Japan-like slump." We were early. We're facing the sushi now. Falling prices. Big output gap. Rising unemployment. On again, off again deflation.

When we considered the risk a few years ago, we came to the conclusion that the United States couldn't afford to wait it out the way the Japanese have. We have too many people who owe too much money to too many wobbly creditors.

But now we're in it. The feds are propping up the wobbly creditors just like they did in Japan. The banks have gotten trillions in loans and guarantees.

The feds have been trying to prop up households too. They recently approved 125% mortgage refinancing by Fannie and Freddie. In other words, they now officially condone...and finance...underwater homeowners. If your house is only worth $200,000...and you owe $250,000...the feds will refinance your mortgage in full. No need to sell and take the loss. No need to let the banks
foreclose. No need to face reality. Now...you can just stay underwater - indefinitely.

The feds are preparing to keep the whole economy on life support - with oxygen provided by quantitative easing. Eventually, of course, they'll run out of gas. But that could be far in the future...

Government deficits are getting worse and worse. Tax receipts are falling. The US deficit for June came to $94 billion...a new record. And the budget deficit has topped $1 trillion for the first time ever. This is also exactly what the Japanese did. They ran the biggest deficits in history. And still the yen went up!

As we keep saying...inflation is no sure thing, at least not in the short-run. But Chris Mayer believes that "the problem with the deflation arguments long term, it seems to me, is that you are betting against a government's ability to destroy its own currency. Governments are seldom good at anything, but one thing they are undeniably good at is destroying their own currencies. The dollar has lost 95% or so of its value since 1913. That's a pretty darn good job. Other countries have been even more thorough."

It takes a determined and suicidal central bank to pull off hyperinflation. Like the Central Bank of Zimbabwe, for example.

Until tomorrow,

Bill Bonner
for The Daily Reckoning Australia

• Inflation or Deflation?
• World Economy Faces Hyperinflation or Deflation?
• Deleveraging Will Give Us a Bout of ’30s-Style Deflation
• Hyper-Deflation on the Streets of Paris
• Does it End With the Bang of Inflation? Or the Whimper of Dying Prices?

Ten-year U.S. Treasury bond yields are coming down as investors lose confidence in Tim Geithner's plan. Yes, it's really weird that the U.S. government can successfully auction US$21 billion in ten-year notes at the same time it plans on growing its annual deficit by $1.5 to $2.5 trillion. But it's a weird world we live in. Foreign central banks snapped up 38% of the auction, according to Reuters. This is like buying a lead life vest as your ship goes under the waves.

The Treasury is hawking $187 billion worth of U.S. debt this week. That's ambitious. Most of it, though, is shorter-maturity notes and bills. Only $14 billion in 30-year bonds will be auctioned. Meanwhile, $32 billion in three-year notes is up for grabs to the highest bidder.

The good news for Team America is that Treasuries are joining gold as a safe haven asset. Investors are growing more convinced that the banks are simply lying about future losses they know they'll have to take. The banks don't want to sell impaired assets at a loss. It would force them to ask for more government capital with strings. Or, it would make them insolvent.

So Treasuries go up. But the bad news is that yields are creeping up too. The three-month yield is at 1.41%, the highest it's been since November. It's an extremely boring subject, but if you look at the composition of America's publicly traded debt, more and more of it has shifted to the short-end of the interest rate curve, 2-year, 5-year notes and 10-year notes. If you get a sudden spike in interest rates, the cost of these monthly auctions--and there are going to be a lot of them this year and next--goes dramatically up for Uncle Same.

Dig deep you taxpayer you!

What would cause a sudden spike in interest rates? It's not what. It's who. The bond vigilantes!

This is the media name for the bond traders who scuppered Bill Clinton's big spending plans during his first term. Back then, the market was capable of imposing some fiscal discipline on the U.S. government by forcing it to pay higher rates of interest for the debt it sold to finance its spending plans.

Today, those spending plans are much larger. The government is not behaving in a fiscally disciplined way. But the bond vigilantes are at war with the equity nervous nellies. That is, the shock and dread of higher inflation that would normally accompany such big spending plans and send rates higher is at odds with the paralyzing fear that owning stocks is an even bigger risk than owning U.S. Treasury bonds and notes.

Maybe this was Geithner's plan all along. Drag his feet on the bank plan to maintain the foreign bid on U.S. debt. Sell the debt to finance the stimulus, then screw the bondholders later when you have to monetise the debt to finance the aggregator bank. Hey, it's not so unlikely is it?

Reuters reports that, "The Bank of England will probably have to ease monetary policy further to get the economy growing again, and could start buying gilts as soon as next month to achieve that, Governor Mervyn King said on Wednesday." Quantitative easing is pure money printing. The central bank prints money to buy government debt. Someone has to buy that debt, you know. And if no one in the marketplace is going to do it, in steps the central bank.

This is a recapitulation of the strategy in Japan that failed. It's a preview of what the U.S. will probably do as well. The government is pouring trillions into the sinkhole of a decade's worth of bad investment in residential housing. All that money--which is capital not going to the private sector to build tomorrow's factories which would create tomorrow's jobs and incomes--is borrowed from the future. The interest on it will have to be paid with higher taxes.

What has the government done to our money? More on that tomorrow.

We have to call it quits on the DR for today so we can wrap up the February issue of Diggers and Drillers. The flip side of the snowballing U.S. public debt is, of course, the rise in precious metals and inflation hedges. If there is a "golden parachute" the inflationary crisis, it's going to be in the metals that have historically been money. As the bullion angle is well covered elsewhere, we've taken a look at platinum this month, as well as the Aussie gold miners and which ones are most likely to follow bullion up, should it keep going up.

One last note. Brokers and talking heads are talking up gold. That's worrisome in the short-term. It means you could see a big spike up in gold back to $1,000. And then? Profit taking. That doesn't change our long-term outlook at all. Just keep in mind that any time you get this much momentum, it's bound to exhaust itself. You'll get a shakeout, a consolidation, and, if we're right, a resumption of the move higher.

Until tomorrow!

Dan Denning
for The Daily Reckoning Australia

• Choking on Debt in the Unfolding Anglo-Saxon Bond Crisis
• Central Bankers Encourage Debt Booms That Become Debt Bombs
• U.S. Treasury Auctioning Off $81 Billion in New Debt
• Finding Assets that Out Run Inflation as Bond Yields Move Up
• Bogus Bond Bust