I’ve been telling people privately to watch the bond market for about a week now. Since last Thursday, we’ve seen a very sharp, fast drop in prices for medium and long-term US Treasury securities, which (in consequence) increases yields. The yield of the 10-year note, which is a critical indicator for mortgage rates, has leapt up above 3.70%, from below 3% just a few weeks ago, and from 2% at the beginning of the year. The yield curve is now steeper than it’s been in decades.

I was wary of saying too much in public because there are indications that some of the plunge in note and bond values was due to technical market factors. The move was echoed somewhat by a fall in the dollar, but gold and oil have been relatively quiet. Corporate bonds have been on fire, with raging demand from a variety of buyers, and swap spreads are compressing rapidly.

The stock market finally got the news yesterday (falling 2%), about the same time as the mainstream press. In general, whenever you see headlines about arcane financial issues, start by assuming the opposite.

The market this morning is showing mild improvement, as it has each day this week in early trading, with yields on midcurve notes and the long bond down about five basis points or so. Yesterday was full of drama, however, as prices for mortgage-related assets (MBS and agency debt) suddenly plunged even after the Treasury completed a decently-received issue of new 5-year notes.

What is happening, in a nutshell, is that…

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Ok, so the essence of Obama’s fiscal policy is to increase taxes and fees on business and on the top-earning 5% of the population. Everyone else gets tax cuts and vast increases in services, like national health insurance and enforced production of electric cars. And of course, the government has to keep stimulating the economy, because shlubs like you and I are so uncertain about the economic future that we’d rather save our money than spend it.

So what do you do when you’re the latest in a long line of Presidents to pledge fiscal responsibility while spending world-record amounts of money? You borrow the money you need to keep the string going. Obama’s first year in office will see a deficit of almost $2 trillion, about four times the biggest deficit that George W. Bush ever ran.

There are two problems with this, one minor and one serious. The minor problem is that Obama promised us a fiscally-responsible Presidency. He’s on record with a promise that when he leaves office, the Federal deficit will be no larger than 3% of GDP. (His first one will be 12% of GDP.) That’s not a problem because Obama can say whatever he wants and people will believe it. He will certainly claim that he fulfilled this promise, and be given credit for doing so, regardless of reality.

The serious problem is that no one knows what the impact will be of borrowing a trillion or more dollars every year for the forseeable future. Today, the public debt of the US is a bit more than 40% of GDP.  Sometime in the next five to ten years, it will hit 100%. Already there are signs that the bond markets are starting to find it a lot less attractive to lend money to the US Treasury.

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This one is odd, and it has a few moving parts I haven’t figured out yet, but you still need to know about it.

In case you hear the Administration start bragging about a sudden reduction in this year’s deficit by about $175 billion, here’s what they’re talking about: they’re going to reduce the amount of the TARP outlays by that much.

No, that doesn’t mean they spent less than $700 billion. (Well, actually, a bit less than $600 billion has been spent so far, but they’ll spend the rest and may need more later.)

It means they won’t add the whole amount to what they say the deficit is.

How are they going to get away with that? By accounting for the TARP outlays on a net present value basis rather than as cash outlays. Think about it like this: the stimulus/porkulus funds are different from TARP. The government either borrows or prints money, and then hands it out to state governors to spend on salaries for unionized teachers, bureaucrats, and hospital administrators, and for things like the John Murtha Airport, bike paths to nowhere, and hamster subsidies for Nancy Pelosi.

Those are pure cash outlays. From our point of view as taxpayers, it’s pure waste, money flushed down the toilet.

But the TARP funds are, and always have been, different. Approximately $17 billion of the TARP was used to buy Christmas presents and holiday bonuses for unionized employees of GM and Chrysler (that money was wasted). The rest was used mostly to buy preferred stock (and in Citigroup’s case, common stock) in something like 200 banks and non-bank financial institutions.

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Somewhat peevishly, the President went to some lengths to portray his current budget as fiscally disciplined. One supposes that he gave his people the mandate to find some impressive number of programs to cut, amounting to some impressive dollar amount. In the event, he got 121 cut programs (most of the cuts had already been announced, like the F-22 Raptor), amounting to $17 billion.

Now you know that Congress will restore most, all, or more than all, of those cuts. And you know that Obama knows that, too. So obviously, the whole exercise was intended to give him a sound bite and nothing more. But look, that matters tremendously, because from now until the end of his term in office (and beyond), Obama will say that he was the first President in goodness-knows how long to actually cut the budget.

For proof, he’ll have the news headlines: “Obama cuts $17 billion in spending; Starts making the hard choices; Down-payment on Fiscal Responsibility.” Repeating lies endlessly makes them true.

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Tim Geithner went to market today to sell 30-year bonds, and he got plastered. The interest rate shot up past 4.28%, and it pulled up the rest of the right side of the yield curve. The auction went unexpectedly bad as there were relatively fewer bids than in the past.

Before you rush to say it, no, the Chinese weren’t in there buying. But that part is NOT a surprise, because foreigners and central banks generally stick to buying short-dated securities. China stopped buying our long bonds back in 2007.

One of my colleagues reminded me that Britain and Germany had serious failures to sell debt earlier this year. The US Treasury borrows in its own currency, so they have nothing like the constraints that the Germans or the Brits do. At least in theory, the Treasury could borrow at any interest rate necessary to clear the market, because they can print money to pay the interest.

The problem is that if the risk-free rate is extremely high in any particular stretch of the yield curve, it necessarily raises the corresponding interest rates for actual business borrowing, possibly to the point of choking off actual business investment.

But it’s funny, because this whole conversation is the kind you’d have in normal times. These aren’t normal times. Bank credit is exceptionally scarce at any price, for more than one reason. Geithner is already using coded language that suggests to me that he finds this ultimately acceptable, so long as government entities can create credit themselves.

And at the end of the day, it truly is frictionless for the government to create credit. But the problem is that there will be very few organic market signals for allocating it, which is a fancy way of saying that the economy won’t be producing things people actually want to buy.

If nothing changes, then ten years from now, Americans will be telling each other Euro-style things like “I work to live, man, I don’t live to work,” and “as long as I have what I need and my retirement is guaranteed, I don’t really need anything more.”

And Obama will get credit for making America a kinder, gentler place. It’ll be really boring, though.