As a rational investor, I understand that sentiment and irrational expectations can impact the market over extended periods of time. When this happens, I focus on the longer-term picture in order to retain conviction in my positions.

But sometimes the market gets so disconnected from reality that I can’t help but wonder whether a significant change in asset prices is imminent. In these instances, which I believe is happening now, I take short-term, contrarian positions.

#-ad_banner-#Even if I am early to the party and lose money on the position over a few months, I am positioned to win big when the bubble bursts. Unlike past bubbles in the stock and real estate markets, a new bubble is emerging in the fixed-income markets.  

Take My Money, Please
Switzerland recently became the first country to sell 10-year Treasuries at a negative yield. In effect, investors are paying the Swiss government to hold their money for ten years and asking nothing in return.

Do investors really expect rates to go nowhere for the next decade?

If that were not enough to signal something terribly wrong in the world of fixed-income, then consider this. The 10-year U.S. Treasury bond yields only one third of a percent more than the yield for equivalent Spanish and Italian governments. Said another way, the safest investment in the world (U.S. Treasuries) is barely paying a higher return than bonds of two country’s bonds that were recently on the brink of economic collapse.

The entire concept of risk and return has broken down for the bond market. Investors are not pricing risk to come to an appropriate yield. Instead, they are responding to central bank moves, which have taken full control of the markets.

I have been generally supportive of the U.S. Federal Reserve’s monetary programs, which have helped to jumpstart the economy through lower rates. It’s hard to complain when the S&P 500 has tripled since March  2009.

Are Investors In Denial About Rate Increases?
Even as the recent jobs report dampened expectations for a rate increase, New York Fed president William Dudley told Reuters that certain scenarios would lead to earlier-than-expected rate hikes.

Fed Chair Yellen and the rest of the doves may appease investors by holding rates at current levels when the Federal Reserve Open Market Committee meets in September. But there is little doubt that higher rates are coming for U.S. bonds.

The FedWatch survey at the CME Group estimates a better than 75% chance of higher rates by January, with a 45% chance that the Fed will lift rates by 0.5% or more.

In the month to early March, it appeared that strong economic growth would push the Fed to raise rates by mid-year. As a result, the yield on the 10-year U.S. Treasury jumped 34%, to 2.24%. However, such expectations have since cooled.

Beyond continued economic strength in the United States, the economy in the European Union is showing signs of life after GDP growth of just 0.8% last year. On the heels of improving manufacturing activity in March, the European Commission forecasts regional economic growth of 1.7% for 2015, the best rate since 2011. Supporting sentiment with the potential for faster growth, the ECB still has 18 months left on its new monetary program to pump more than $1 trillion into the economy.

Meanwhile, the bond market is asleep. The iShares 20+ Year Treasury Bond ETF (NYSE: TLT) is trading just 5% off its all-time high set in January. The price of the bond fund is 10% higher than in December 2008, when the world rushed to safe U.S. government bonds. It is even above the July 2012 price when the 10-year yield sunk to 1.4% on fears of a default in Spain.

In late 2013, shares of the TLT fund sank to around $102, 22% lower than its current price. Yet, if global economic growth picks up this year, then we could see the 10-year yield reach 2.5% as the Fed moves closer to a rate hike.

A 2.5% yield translates into a $115 share price for the above-noted ETF. That sets up an opportunity for short sellers, as shares currently trade for around $130.

Risks To Consider: Monetary programs in Europe and Japan could limit how high rates go globally and it may take some time for economic growth to return.

Action To Take –> Take advantage of the current rate environment and the breakdown in pricing of bonds to short the TLT Treasury fund. That move will allow you to profit from a rise in rates and hedge against market weakness.

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