Saturday, April 30, 2011

Does the Bond Market have Inflation Wrong?

You arrive from another planet and are told that inflation is a big problem in the United States. You pick up a copy of the New York Times and based upon your reading of the headlines you would believe it to be true. You read the front page and see stories about increasing oil and other commodity prices and the sky rocketing price of gold and the impact of high energy prices on the spending habits of the consumer. You think that inflation is rampant.
 
On your home planet you learned a great deal about investing in your market from a very early age. Your teachers told you that with increased inflation you have to have higher interest rates. Interest rates have to increase in order to compensate the investor for buying bonds today for the decline in the value of their money caused by inflation.
 
In looking at the Business section of the paper you go to the US Government Bonds pricing section and you see a chart similar to the one on this page. You look at the return on 90 day T-Bills at 4 basis points per year. You stop and think about how little 4 basis points is in 12 months. You calculate that 4 basis points on $100 is about 4 cents a year. That doesn’t seem like much so you look out 5-years and you earn $1.97 per year for your $100 investment. So, one more time you look out 10-years and you find that you can earn $3.29 a year for every $100 you invest. None of these returns make sense if  inflation is truly out of control.
 
If you look at the yields in the Government market place you would not see any signs of inflation that you read about on the front page of the New York Times or any other newspaper. The big question is, “what is the bond market telling us and is the bond market wrong on inflation?" I think there is another concern that the bond market is telling us. It is more important to investors than inflation. We had a GDP report this week and the government said that the initial estimate for GDP in the first quarter of 2011 was annualized to 1.8%. Now the GDP will go through two more adjustments, but right now most economists think we will stay around the 2% level or perhaps a little less.
 
What the bond market is screaming that nobody, but perhaps me, is concerned about or is even talking about, is not inflation or deflation, but a new recession in the economy. Notice I didn’t call it a double dip because we have had a recovery albeit tepid it was still a recovery.
 
I have written in this column in the past that the Federal Reserve is in control of the short-end of the yield curve, but the “Bond Vigilantes” have control of the rate of interest out past a year in maturity. The “Bond Vigilantes” do not seem to be worried about the credit markets at least at the moment. We talk about all the debt we have and how we are spending our childrens and grand childrens wealth to pay the debt. Yet interest rates are falling not only in the United States, but also around the world. The British Bankers Association publishes a daily London Inter Bank Offered Rate (LIBOR). The US Dollar LIBOR interest rate has dropped to its lowest level in the last 14 months, 27 basis points annually for 90-day term.
 
Back here in the United States we have 90-day T-Bills at 4 basis points, The European Central bank moved their short-term interest rate up this past month, but has indicated that they will not move again until the US increases interest rates. They could be waiting a long time.
 
I think that much later, perhaps as late as 2013, we will see an increase in interest rates and that is why we own TBT as a hedge against increasing interest rates. Interest rates will go up and down in the interim, but if  I’m right and the economy turns negative in the fourth quarter  of 2011 to  the first quarter of 2012 then the greatest risk in investing now is the American stock market or for that matter any stock market that is driven by growth expectations. If the US economy turns south later this year, then look for the commodity markets to sink under the sheer weight of their unchecked advance.
 
Wasn't it fun to read this blog? Seriously, they may not all be of good cheer but  they are at least my honest opinion. We will see if my crystal ball is any better than others.
 
 
Dan Perkins
 

 

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