Bonds and Deflation
March 26, 2004
extracts from a commentary posted at www.speculative-investor.com
on 20th March 2004.
Several powerful forces have combined to drive US bond prices
higher over the past few years. Chief among these forces has
been the large-scale buying of US bonds by the Bank of Japan
as part of its attempts to weaken the Yen, but other significant
influences include yield-spread trades by banks and speculators,
strength in Japanese Government Bonds, 'flight to safety' buying,
and fear of deflation. What we want to do today, though, is not
spend time analysing WHY the bonds have been so strong because
we've covered this topic at length in other commentaries over
the past year. Instead, we are going to look at the EFFECTS that
this bond strength has had, and continues to have, on other markets.
One of the most important effects of the on-going strength in
bonds is psychological because regardless of the fact that much
of the strength can be attributed to government intervention
(aggressive buying of US bonds by the Japanese central bank and
the Fed's implied promise to hold the official short-term rate
at a very low level until the employment situation improves),
many analysts won't believe that an inflation problem exists
until after bond prices move considerably lower. In other words,
the consensus view is that if the US really was facing a serious
inflation threat then bond prices would be much lower (long-term
interest rates would be much higher); and this is despite the
mountain of evidence that the on-going bond price strength has
nothing to do with inflation/deflation.
Now, the knock-on effect of very few people perceiving an inflation
problem is that the problem is able to grow because nobody in
power, least of all the governors of the Federal Reserve, is
interested in trying to solve a problem that supposedly doesn't
exist. That is, persistent strength in bond prices prevents any
obstacles from being placed in the way of additional inflation
because the bond price strength places a smoke screen in front
of the underlying inflation problem. This, in turn, means that
the prices of those things that benefit from a burgeoning inflation
problem are able to move much higher than would otherwise be
possible. So, the longer that bonds can remain firm the higher
the prices of gold and commodities will eventually move. By the
same token, there won't be any need for us to worry about commodities
and gold experiencing anything other than routine bull-market
corrections until bond prices move sharply lower.
The problem or the solution?
Over the past few years it has often been necessary to think
counter-intuitively in order, firstly, to understand what is
happening in the markets and, secondly, to understand the likely
future effects of these happenings. For example, during the weeks
immediately following the devastating terrorist attacks of 11th
September 2001 there was substantial strength in bonds and widespread
fear of deflation. Our interpretation, though, was that the policy
response to the situation was going to result in an even bigger
inflation problem and rally in commodity prices than would otherwise
have occurred. But this interpretation seemed so 'off the wall'
at the time that several of our readers actually cancelled their
In the last two commentaries we've begun to once again discuss
the 'deflation bogey' because there's a reasonable chance that
financial-market and economic conditions during the second and
third quarters of this year will once again cause deflation to
become a hot topic; and we wanted to get in early with our rebuttal.
Of course, just because we were right about this issue when deflation
fears were rampant during 2001, 2002 and 2003 doesn't mean we
will be right this year.
We think it is very likely, though, that the PERCEIVED deflation
threat will once again be met by a very aggressive inflationary
response on the part of policy-makers. Furthermore, given the
Fed's enormous power in the field of money/credit creation there
is a high probability that the inflation problem will be made
much worse before we have to seriously consider the possibility
of genuine deflation. And, if policy-makers are lucky (they will
need to be extremely lucky) then their efforts to magnify the
existing inflation problem will once again be masked by stability
or strength in the bond market.
A point that deserves to be emphasised, though, is that when
the Fed and other central banks facilitate the creation of additional
money/credit in order to 'address' a perceived deflation threat
all they are actually doing is pushing an even bigger problem
into the future. This is because deflation isn't the problem;
the problem is that way too much new money and new debt has been
created over the years. That is, there is an inflation problem
and deflation, in fact, is the only viable long-term SOLUTION
to the problem.
Further to the above, at the root of the matter is the common
misapprehension that deflation is the problem and that inflation
might be a solution, or, at least, a 'bandaid' that can be applied
in order to make the healing process less painful. In our opinion,
though, inflation is the PROBLEM and deflation is the SOLUTION;
and the problem will continue to get worse until the political
will exists to fix it.
Commodities, Gold and Inflation
Rising commodity prices are a potential EFFECT of inflation,
but it is generally possible to explain an increase in commodity
prices without naming inflation (money supply growth) as one
of the culprits. For example, right now an argument could be
made that commodity prices are not strong as a result of inflation
but are, instead, strong as a result of China's economic boom,
weather-related problems, geopolitical issues and OPEC production
The ability to blame price rises on anything other than inflation
is one of the main reasons that price indices such as the CPI
have been aggressively promoted by governments over the decades
as measures of inflation; the idea being that as long as most
people believe that rising prices and inflation are one and the
same then it will be possible to blame "inflation"
on things over which the government has no control, such as the
weather. So, how would we ever know that inflation was one of
the main forces behind a rise in commodity prices?
The answer is: the performance of the gold price. Specifically,
when gold leads a large and lengthy rally in commodity prices
we can be very confident that one of the major forces behind
the rally is inflation. This is because the investment demand
for gold only rises when confidence in fiat currency falls.
And gold leadership is exactly what we've seen over the past
three years. Note, in particular, that the gold price reached
a major bottom (in real terms) in February of 2001 and had been
rallying for 8 months by the time the CRB Index hit a major bottom
of its own. We can therefore be very confident that inflation
has played an important part in the rally in commodity prices
that began in October-2001.
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