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Gold, Bonds, and Inflation

What's the Best Fear Trade?

Written by Geoffrey Pike
Posted May 15, 2015

There is no shortage of news these days, with Tom Brady being suspended for supposedly knowing about deflating footballs to a growing list of presidential candidates for 2016.

Even in financial news, the price of oil — and gasoline along with it — is heading up, and stocks are bouncing around near all-time highs.

Also in the financial arena, but not getting quite as much attention, is interest rates ticking up. And for Americans, there is little news about the big moves in interest rates from overseas.

The U.S. 10-year yield, which is also highly correlated with 30-year mortgage rates in the U.S., has gone from under 2% to about 2.3%. While this is big in percentage terms because rates are so low, it is not an earth-shattering move in any sense.

However, when you look at the big players overseas, the moves have been quite significant, and we have to try to make some sense of it all.

The German 10-year yield has popped up to over 0.7%. While this is absurdly low, it is a huge jump when you consider it was around 0.1% just weeks ago.

The Japanese 10-year yield has also risen from around 0.2% back in January to over 0.4% today.

The 10-year yield on Swiss bonds was getting deeper into negative territory but has popped back up into positive territory on big moves in just the last couple of weeks.

The rest of Western Europe has been seeing similar trends, with 10-year yields in Italy, Spain, and the U.K. all rising quickly in the last few weeks.

Since bond prices move in the opposite direction of interest rates, this means bond investors have been hammered over the last several weeks. The big question is whether this was just a little pullback in a big bull bond market or if it is the beginning of a bond implosion.

A Bull Market in Bonds

Interest rates have trended down since the early 1980s. For nearly 35 years, bonds have been a reasonably good investment, at least in the United States.

Bonds were a terrible investment in the 1970s, with interest rates going well into the double digits. There have been ups and downs in bond prices since then, but a lot more ups than downs.

Bonds and treasuries are typically considered safe-haven investments. This is not true if you are talking about Greek bonds, while for the U.S., it is considered about as safe as you can get.

There is almost no risk of default in U.S. Treasuries, and it is likely to stay that way for the foreseeable future. But you never know how things can play out in 10 or 20 years.

The big risks with U.S. bonds are rising interest rates and inflation. Rising interest rates decrease the value of the bonds. Rising inflation means you will get paid back in money that is worth less than when you bought the bond. Your nominal returns will not be affected, but your real inflation-adjusted returns will be.

Interest rates reflect the time value of money if left to the free market. Interest rates will also change based on inflation expectations. There can be higher interest rates as part of a default premium as we see in Greece, but this is basically a non-consideration for U.S. debt at this point.

Over the last seven years, the Federal Reserve has had three rounds of so-called quantitative easing. Part of this newly created money was injected by buying U.S. government debt. Prior to 2008, all money creation by the Fed was injected through bond and Treasury purchases. Since that time, the Fed has also bought mortgage-backed securities as a way of quietly bailing out the banks.

There is no question that the Fed has purchased a lot of U.S. debt, including longer-term bonds. When you have an entity as big as the Fed buying tens of billions of dollars each month, it is going to move the market.

The interesting thing is that rates did not pop up when the Fed wound down its latest round of quantitative easing last year. Rates did not pop up on talk of the Fed hiking the federal funds rate, or if they did, they quickly came back down. With the Fed doing almost nothing, the 10-year yield still sank below 2%.

There is major digital money printing in Europe and Japan, so this can help explain the ultra-low yields there, but even that is not the entire picture.

Why Bonds?

Aside from central bank buying, why would bonds go up in price? Why is there such high demand for them (at least until just recently)?

I believe the main answer is fear. As I already mentioned, bonds are considered a safe haven in most developed countries.

When you have an unstable currency and price inflation expectations are high, people will run to hard assets such as gold. But when price inflation expectations are relatively low and there is fear, investors go to bonds.

The economies of Europe and Japan are not in good shape. There is a lot of desperation. There is a lot of fear. In recessionary conditions, cash is king, as long as your cash is not losing purchasing power too fast. People are also willing to lock in low rates of return.

This is why we see negative interest rates. If you were living in Greece, you would much rather own a Swiss bond that pays a negative interest rate than keep your money in a Greek bank that could go bust. Even people in other parts of Europe might find it safer to put money in Swiss bonds as opposed to keeping it denominated in euros.

Even in the United States, there is still fear left over from 2008. Unemployment has gone down, but it is not the same economy as it was before. People are still struggling. The demand for money is still high, which is also one reason price inflation has stayed in check.

When inflation expectations are low and there is fear, investors buy bonds. It is the best recession hedge there is in a non-inflationary environment.

Price Inflation Before Interest Rates

Is this the end of the bond bubble? Is it time to start shorting bonds?

While interest rates could easily go up more, I don’t think we are about to see anything drastic yet, particularly with U.S. bonds. We are likely to see higher price inflation first.

We have already seen a great amount of monetary inflation over the last seven years. But much of this new money went into bank reserves and was not lent out. That, coupled with a high demand for money (low velocity), has meant relatively low consumer price inflation.

We have seen asset inflation, particularly in stocks, but consumer prices have been tame compared to the Fed’s money creation.

I don’t see fear going away anytime soon, either in the U.S. or globally. In the U.S., there will not be any fear of a U.S. government default. Therefore, the only way I see interest rates spiking up a lot is if we see a pickup in price inflation.

For this reason, I would prefer going long gold at this point to shorting bonds. While rising interest rates could be a sign of higher price inflation ahead, it is probably more likely that gold would lead the way higher. Buying gold is also the safer bet. If we see another recession in the U.S., you will not want to be shorting bonds because interest rates are likely to fall back down further.

If you live in Japan or Western Europe, you should definitely prefer gold to bonds. The European Central Bank and the Bank of Japan are in money-creation mode, and you don’t want to fight that.

Even in the U.S., although the Fed is currently not in money-creation mode, consumer price inflation could still show up if banks decide to lend out a portion of their reserves.

Since the Fed is in tight-money mode now, you also can’t discount an economic slowdown or outright recession. The first-quarter GDP was not at all impressive. If we see a recession, then interest rates will likely fall and bonds will go up, assuming price inflation stays in check.

If you were short bonds over the last few weeks, you did well. But that was just a blip. Bonds may have just been overbought and needed a little correction, although it is still too early to tell.

There will come a time when shorting bonds for the longer term will be quite profitable. That will be the bursting of the bond bubble after 35 years.

This could be the start of it, but it's not likely. We will likely see higher price inflation expectations and a higher gold price first.

Until next time,

Geoffrey Pike for Wealth Daily

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