Global Agenda: Capitulation

To deflationists, the recent slump in bond prices and jump in yields is a tremendous opportunity.

December 16, 2010 23:19
4 minute read.
Federal Reserve Chairman Ben Bernanke

FED Chairman Ben Bernanke 311. (photo credit: Associated Press)

The yield on US government long-term bonds has soared in recent weeks. The longest widely traded bonds, those with a 30-year maturity date, have suffered a sharp fall in price and corresponding rise in yield (prices and yields move in opposite directions; if you don’t understand why, don’t worry – just accept it).

On Wednesday, the yield briefly rose above 4.6 percent per annum, compared to a recent low-point of about 3.7% in late October and early November. For the 10-year bond, the parallel rise in yields was from 2.4% to 3.5%.

These are enormous moves, in the context of the bond market. If you hold a 30-year bond, you suffered a massive loss on paper over the last six weeks, because the 0.9% move in yields (4.6% to 3.7%) is multiplied by 30. For the 10-year bond, the 1.1% rise in yields translated into a smaller decline in price and hence value because although 1.1% is more than 0.9%, it is only multiplied by 10, not 30.

But the actual move in prices and yields is only part of the story. No less significant is the timing. Late October to early November saw bond yields reach their lowest levels (and prices their highest) since the darkest days of the financial crisis at the end of 2008 to early 2009. However, the economic background in September-October was one of mild optimism, certainly not imminent disaster. Why then were bonds so strongly in demand? The answer is that Federal Reserve Chairman Ben Bernanke had announced in late August that the Fed was going to undertake a large-scale effort to stimulate the economy and prevent it slipping into a dangerous deflationary spiral by buying medium- and long-term government bonds. This expectation fueled a powerful rise in bond prices over the next 10 weeks or so, pushing yields down to the very low levels noted above.

But, almost immediately following the formal launching of the Fed program – widely known as QE2 (i.e., second round of quantitative easing, or monetary stimulus) – the bond market changed direction. This was the exact opposite of what had been expected, since almost everyone believed that bonds would continue to rise. But, in a classic example of “buy the rumor, sell the fact,” the expectations were dashed because they had already been fulfilled.

Everyone who wanted to buy had done so ahead of the actual operation, on the basis of the pre-announcement.

Yet the scale of the move these last six weeks is much greater than any “contrarian” or profit-taking tactics would seem to justify. Consequently, analysts are desperately seeking a more fundamental cause for this development. A widely held idea is that the Fed program will cause inflation, maybe even hyperinflation.

Since Bernanke has stated explicitly that the inflation rate is too LOW, and that his policy is aimed at pushing the inflation rate UP, this view is hardly far-fetched. Higher inflation is very bad news for long-term bonds because their value is fixed in nominal terms and is therefore vulnerable to erosion by inflation over the course of their lives.

However, the actual inflation data continue to demonstrate the absolute absence of inflation in the American economy, as is the case in virtually all developed economies. Only in China and some other rapidly growing developing economies is inflation a real and present threat, and the Chinese central bank is belatedly moving to deal with this problem.

The argument that the US economy is threatened with inflation rests on the belief that this will develop down the road. The counterargument, that the US is threatened by deflation, is supported by the current inflation data. But the deflationist school has to explain why Bernanke’s efforts will fail and why inflation will not rise in the future.

The small but important deflationary school does indeed have a coherent – and, to my mind, convincing – explanation.

If you can get hold of material from Gary Shilling or David Rosenberg, you will find the answers there. But, as noted frequently in this column, the bottom line is that you must have an opinion on the inflation-deflation debate because it is the basis on which you will construct your financial strategy and your investment portfolio.

To deflationists, the recent slump in bond prices and jump in yields is a tremendous opportunity. They believe that the American economy is too weak to generate any inflation and that yields will fall back during 2011 from their current highs. The last few days, in which prices have fallen especially rapidly, may well reflect the capitulation stage wherein many bond investors throw in the towel and sell their holdings, thereby exacerbating the trend that caused them to give up. But that is exactly the stage at which one ought not to sell and at which brave souls plunge in and buy.

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