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The Bond Market Has it Wrong

Peter Schiff
Aug 18, 2006

Perhaps Abraham Lincoln would never have devised his famous adage about fooling all the people all the time if he had a chance to observe the current bond market's complete obedience to Fed propaganda. In an exercise in mass hypnosis that would have made Orson Wells jealous, the Fed has managed to convinced bond investors that inflation no longer matters. This is like convincing major league managers that batting average no longer matters. It was a long process, but for now at least, the Fed should celebrate their communications victory, at least until the actual carnage becomes too heavy to ignore.

In an article earlier this week in the Wall Street Journal, as in many other recent media reports, a professional bond investor says that he is no longer focusing very intently on CPI reports. After all, says the bond trader, the Fed has said that growth is the thing to watch now and that any current signs of rising inflation are backward looking. As a result, at a time when even the most watered down data reveal that inflation is running at its fastest pace since the early 1980's, Treasury yields have remained significantly below the current 5.25% Fed funds rate. How could this have happened? How could professional bond investors speed through these stop signs at 75 mph? It happened step by step.

The first step was convincing the markets that hedonic adjustments were okay. Next came the legitimization of substitution bias. Then the Fed convinced everybody to ignore monthly increases in food and energy. When that wasn't enough, it got everybody to ignore yearly increases in food and energy. Finally, when even all these tricks were not enough to conceal the growth of inflation, the Fed finally played its trump card by telling the markets that inflation is the poor step-child of its much more import parent, GDP growth.

This week, when the government reported better then expected PPI and CPI, data, the bond market went ballistic, as traders took the government's bait hook, line and sinker. Equities went along for the ride, and a good time was had by all. Lost in the shuffle was the renewed weakness in dollar, which has lost about 2% of its value relative to other currencies over the past month. The Fed pause has given currency traders the "all clear" to sell the dollar. Combine that with a poor technical outlook and I look for the dollar to meet with some intense seller pressure in the coming months.

Since the value of the dollar is the single biggest determinate of prices, it is amazing that Wall Street can celebrate a victory over inflation based solely on one month's data despite the poor monthly performance of the dollar itself.. If the dollar continues to lose value, it's only a matter of time before sellers demand more of them in exchange for their wares. If they fail to raise their prices, the net effect is that they suffer a price reduction. So while Wall Street looks to the bond market as evidence that inflation is well contained, the smart money looks at the forex markets to realize just how much worse inflation is likely to get. Remember, bond yields do not reflect what future inflation actually will be, only what bond investor think it will be. Action in the currency markets will reveal just how wrong these bets are likely to be.

Place your bets now before the rest of the world figures out the truth.
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Peter Schiff
C.E.O. and Chief Global Strategist
Euro Pacific Capital, Inc.
1 800-727-7922


Mr. Schiff is one of the few non-biased investment advisors (not committed solely to the short side of the market) to have correctly called the current bear market before it began and to have positioned his clients accordingly. As a result of his accurate forecasts on the U.S. stock market, commodities, gold and the dollar, he is becoming increasingly more renowned. He has been quoted in many of the nation's leading newspapers, including The Wall Street Journal, Barron's, Investor's Business Daily, The Financial Times, The New York Times, The Los Angeles Times, The Washington Post, The Chicago Tribune, The Dallas Morning News, The Miami Herald, The San Francisco Chronicle, The Atlanta Journal-Constitution, The Arizona Republic, The Philadelphia Inquirer, and the Christian Science Monitor, and has appeared on CNBC, CNNfn., and Bloomberg. In addition, his views are frequently quoted locally in the Orange County Register.

Mr. Schiff began his investment career as a financial consultant with Shearson Lehman Brothers, after having earned a degree in finance and accounting from U.C. Berkley in 1987. A financial professional for seventeen years he joined Euro Pacific in 1996 and has served as its President since January 2000. An expert on money, economic theory, and international investing, he is a highly recommended broker by many of the nation's financial newsletters and advisory services.

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