Warning: Inflation > Ten Year Treasury Yields = Bond Price Plunge

Bloomberg carries a story today, “Treasuries, Oil May Foreshadow Bear Market After Yields Tumble,” that warns that the Treasury rally, driven by a flight to quality, may not simply be short-lived but a precursor to a nasty reversal, particularly on the longer end of the market. It suggests that those that see the recent decline in long bond rates as a sign of lower inflation expectations may be kidding themselves.

Note that the story quotes not only the high profile Jim Rogers, but a less widely known bond market luminary, Craig Coats, the head of Salomon Brother’s fearsome government bond market desk in its heyday in the 1980s.

From Bloomberg:

For only the fourth time since Gerald Ford’s presidency, oil is threatening to push the rate of inflation above 10-year Treasury yields. For bond investors basking in the biggest bull market since 2002, that’s bad news.

Yields on 10-year notes fell as low as 3.79 percent last week, within a third of a percentage point of the consumer price index. Every time inflation has exceeded what investors get paid to own Treasuries, bonds have plunged…

“It’s like the 70s,” said Jim Rogers…

“We’re in a period of a commodity bull market and inflation,” Rogers said. “I would not buy government long-term bonds. We’ll be going down for years to come. Commodities are telling you to sell Treasuries. Inflation is everywhere.” He holds positions that will benefit if Treasuries fall…

“The inflation story going forward is going to be very different than what we’ve seen in the past,” said E. Craig Coats Jr., co-head of fixed income at Keefe, Bruyette & Woods Inc. in New York, who began trading bonds in 1969 at Salomon Brothers. “The inflation news is going to be worse.”…

“You’ve got to be thinking inflation is falling by a dramatic amount” to buy bonds at their current yields, said Thomas Atteberry, who manages $2.3 billion in fixed income assets at First Pacific Advisors LLC in Los Angeles. “I’m a little hard pressed to see that with the price for oil and the prices we’re seeing for food. It’s unsustainable.”….

The central bank highlighted inflation concerns when it lowered its target for overnight loans between banks by a quarter point to 4.5 percent on Oct. 31. “Readings on core inflation have improved modestly this year, but recent increases in energy and commodity prices, among other factors, may put renewed upward pressure on inflation,” the Fed said in its statement…

Keefe, Bruyette’s Coats said his forecast for faster inflation is based on demand from China, India and other emerging-market economies for oil and other commodities, demand that wasn’t there in the 1970s. Global growth presents investors with “a very different scenario” than earlier periods, he said….

Both instances of negative real yields in the 1970s were caused by the central bank’s unwillingness to tackle rising prices by raising rates, said Lyle Gramley, a Carter economic adviser from 1977 until he was appointed a Fed governor in 1980.

Carter’s appointment of Paul Volcker to head the Fed in 1979 was an acknowledgment of the severity of the economy’s problems, Gramley said in an interview. “There wasn’t any alternative other than very tough monetary policy.”

Volcker ended up boosting the central bank’s target rate to 20 percent in 1980. Should real yields swing into negative territory it will be a “unique” consequence of the flight to quality, Gramley said.

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  1. a

    So where are you supposed to put your money? Citibank stock? Gold?

    The reason people are buying Treasuries is that they don’t really mind a 0% real interest rate; they just want to be reasonably sure they are getting their principal back. (Mind you, I’m mystified why they aren’t buying TIPS.)

  2. Anonymous

    Yves, will any presidential candidate have the stones to appoint a Fed chair willing to raise rates? Easy money got us into this mess, easy money isn’t the answer.. the US needs Volcker II.

  3. Anonymous

    This is nothing like the 70’s.

    Rogers can’t distinguish between 70’s inflation and the 00’s risk of a deflationary bust.

    China is unsustainable on a cyclical basis. People assume there is no cycle in China. That’s a huge mistake.

    If China does turn down, and US monetary policy is too tight, we will surely be immersed in deflation.

    US treasury yields in the 70’s acted NOTHING like they’re acting today. That’s important.

    If the risk of 70’s inflation was real, treasury yields would already be reacting. One reason they’re not is that elevated credit spreads are already disproportionately high relative to the yield level of treasuries, meaning that the risk component of interest rates is extraordinarily high on a relative basis, meaning that current credit conditions are extraordinarily tight and current monetary policy all-in (risk free plus risk) is extraordinarily tight.

    The 70’s comparison is all wrong.

    The secular risk is as it has been for the last 15 years – deflation.

    Deflation risk means debt deflation risk, where those debts that don’t default continue to go underwater due to liabilities that become increasingly expensive when denominated in money that is increasing in real value.

    Debt deflation is a disaster and the seeds of it are already in place with the ongoing credit destruction.

    Tightening monetary policy would be an absolute disaster and the Mount Everest of policy stupidity at this stage.

    Rogers’ diagnosis and prescription belongs in the wing nut hall of fame.

  4. sen-c

    Whatever virtues one might bestow on Volcker for dramatically rising interest rates to combat inflation, one consequence (among many) was to drive down wages . . . which have never fully recovered. As a result, in order to expand consumption in the US, the economy relied increasingly on debt creation as a substitute for income.

    Now we’re left with the prospect of debt destruction . . . which seems more in line with a deflationary outcome than one that is inflationary as suggested in the Bloomberg piece. This is not to suggest that some form of stagflation won’t exist for a time, but my hunch is that deflation will rule at the end of the day.

  5. NC Jim

    My SWAG:

    Deflation in financial assets

    Inflation in real assets

    Resulting vector is stagflation

    Housing is behaving as a financial asset due prices were set my the ability to engineer a temporary low payment. Once house prices decline to replacement value, they will begin acting as a real asset.

    My current opion for what it’s worth.

  6. NC Jim

    Horrible typing. He meant to say:

    Housing is behaving as a financial asset since prices were set by the ability to engineer a temporary low payment.

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