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.