Over the past couple of weeks, long-term treasuries have been in freefall. Yields have been rising, meaning the government has to pay a higher interest rate on its debt. At first, some believed it was merely a return to more appetite for risk; treasuries are boring, but stocks are sexy. That may explain part of it, but it is becoming crystal clear that bondholders do not trust the US government’s deficit situation over the long-haul.

We are runing deficits in the 12-20% range currently. That is unsustainable and everyone knows that. However, the long-term picture isn’t any brighter. With medicare ballooning and baby boomers about to retire and get social security benefits, our entitlement system is about to collapse the economy. More entitlements for the elderly and a shrinking tax base does not bode well for the federal government’s fiscal health. While the government can raise taxes, it is hesitant to do so during a recession, and the amount of taxes they will raise will likely not be enough to cover the deficit.

Gambling on treasury bonds isn’t about what the government should do; it is about what the government will do. The Obama administration has made it crystal clear it will not raise taxes too much, even on higher earners (and raising taxes on them may very well not result in more revenue anyway). The Obama administration has made it clear it looks at the economy with rosy sunglasses and has exceedingly optimistic projections at every turn. It is simply putting its hands over its ears during this mess and saying “I can’t hear you!” when people talk about these long-term deficits because it believes we will have 4% growth in 2011, something we didn’t have even during the boom years, and certainly not something we will have during a more socialistic atmosphere.

Bondholders aren’t going to wait for the government to fix its mess. With the deficits rising, the government’s ability to repay, except through inflation, is questionable. Thus, the rise in interest rates.

The long bond is now over 4.5%, which is what the government targeted for 30 year mortgages. No bank is going to do a 4.5% mortgage when it can loan to the government at 5% and everyone knows that. But, the scary part is that if yields keep rising past 6% and closer to 10-12% in the Carter years, everything will slow to a miserable halt. We’ll have another depression caused by absolutely no credit being available (since it is all swallowed up by the government). Conversely, we’ll have inflation since the government will print some of the debt away. This would be a better scenario, and the one traders are viewing more likely.

In the short to middle run, I see the market going down, treasuries going down, and precious metals rising moderately. Once the Fed starts its ‘quantitative easing’ in full gear though, precious metals will go through the roof, stocks will go up moderately (or stay where they are), and inflation will be the name of the game.

I’m skeptical of the economy and this administration. For an economy to grow in the long run, it needs to be more productive and efficient. The government is throwing trilllions of dollars at unproductive measures (entitlements, bridges to nowhere, etc.) and attempting to fund this by taxing and hurting productive measures (small businesses, profitable multi-nationals), etc. I don’t see our economy doing well in the long run.

However, to make money, it’s important to guess correctly how we’ll slow. If it’s deflation, with asset prices crumbling, shorting the market and buying government bonds is the way to go. This would be a repeat of what happened last fall, when the market crashed and the 30 year T-bill went below 3%.

Many don’t think it will be deflation, rather an inflationary depression. The reason for this is that that the government is hell bent on reflating the economy. It is taking on huge deficits…who will pay them? Scared investors like in the fall? That may have worked then, but how will it fund $2 trillion deficits going in the future? China/Japan have their own problems and we can’t rely on them. Thus, the T-bill should go up in yield (so shorting government bonds would be the play since you would be betting the government would have to pay a higher percentage than they would now to bond investors).

If this happens, the crowding out effect takes place. No small business can get a loan since a bank would rather loan money to the federal government at 10% than loan to a small business at 13%, and few small business can afford to pay that even. To stop this, the government may buy back its own bonds with money its printing, which would result in inflation. In this case, the bets are to short government bonds and buy commodities. Stocks in commodity companies would do well.

As you can see, they are very different playbooks. In pure deflation, you buy government bonds since you think the panic from investors will cause bond rates to go down. In inflation, you short them. In deflation, you sell commodities. Inflation, you buy them.

I’m bearish and lean towards inflation, but recognize I may very well be wrong and it could be deflation. I just don’t think the government will let a deflationary spiral take hold; it is too much in everyone’s interests for the pain to be felt through inflation than deflation.

So Cramer’s been bashing Obama all-week (pretty fun to watch). The guy even voted for Obama, but is now castigating our new president as the greatest wealth destroyer in mankind.

Cramer is a very smart guy. There’s a bunch of people who knock him around the web. You have to remember he’s a TV personality and that he has to avoid saying anything that is too non-PC or give super direct advice, else his audience might over-react and not take into account their own financial situation.

He was very clear about taking 25% off the table before the October drop and even selling it all at Dow 10,000 if you needed the cash in the next five years. As of now, he remains fairly bearish long-term though he seems to think some sort of bounce is inevitable.

He recently said he thought the most bearish case scenario (which might also seem likely) has us at Dow 5300. I could see us dropping down to Dow 5500 and then having a sharp bounce back…perhaps all the way up to Dow 7500-8000 before dropping down to the 4000’s.