Bonds and Deflationwww.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 subscriptions.
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 cuts.
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