Monday, September 28, 2009

What Is The Bond Market Telling Us About Inflation?

Recently two powerhouses took different stands on the merits of owning or not owning the longer-term Treasury Bonds. Bill Gross the President and co-founder of PIMCO the largest fixed income manager in the world. Mr. Gross said he had increased his long Treasury positions to the highest level in many years. While on the other hand Jim Cramer of CNBC Mad Money said that he believed you should sell out of any long dated Treasury positions you owned. So far Bill Gross is winning the battle of the forecasters.

Only time will tell if either is correct, but I think the more important issue at hand is what the bond market is telling us about the prospects for inflation and growth. As I write this blog the yield on the 30-year bond is just above 4% while the yield on the 10-year bond is 3.25%. I suggested in a previous blog that I thought that the yield on the ten-year bond could reach 3% perhaps even go below.

When the majority says that something will have to happen it usually doesn’t. The majority is telling anyone who will listen that inflation is just around the corner and the Fed should be raising interest rates now to stem the tide of potential inflation. I believe that bond market is telling a much different story. The bond market is beginning to price in deflation.

The stock markets are going to 10,000 on the Dow Jones and 1,100 to 1,200 on the S&P 500 if you believe the majority of annalists on the street. The S&P 500 has moved almost 60% off of its March 9 bottom. Lets say that the forecasters are correct that the S&P 500 could go to 1,100 from this level by the end of 2009. If the S&P 500 were to go to 1,100 from this level then the upside is 3.7% of additional return not much risk reward opportunity.

Some time ago I suggested that there were a few simple things you could watch to tell you about the recovery in the economy. One was Jobs and another was the real estate market or single-family home sales and prices. I would like to add one other item to your short list of things to watch and that is the price of gold. Gold is supposed to be the great inflation hedge and everybody should have some right. If you adjust the current price of gold for inflation the comparable price to the previous high is $870. If you were to buy gold today at $1,000 it pays no income and if we are in fact headed for deflation you could loose a great deal of money.

I have been saying for some time that I felt that the recovery, when it came, would be weak and unemployment would stay above 8% for an extended period of time, perhaps several years. It appears that a very small minority believe that we could be in for difficulty for several years to come. I just can’t see the Fed raising interest rates with unemployment above 8%. I still expect to see a slow and low recovery and no change in interest rate policy for several years.

I believe that the bond market is giving us a warning. The bond market is saying that inflation is not a problem and it will not be a problem. People keep asking the question; why are people buying all of the excess of US Treasury debt. They can’t understand why this debt is being sold at such low interest rates and with high demand. I believe the answer is that the buyers don’t see inflation and are more concerned about deflation and a US Government bond is still the safest place to have your money. I also believe that people are trying to put a round peg in a square hole by saying this is what should happen based on the past. There are some people who remember the great depression of the 1930”s. I think all the rules are off the table when it comes to investing money today and the demand for the treasury debt is sending a loud and clear signal.

The people who maintained their wealth in the last depression did so by buying Treasuries not common stock. If you are not convinced that the future is not as rosy as many are predicting then you are buying or should be buying Treasuries across the entire maturity curve. My money is on Bill Gross.

Dan Perkins

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