Below is an extract from a commentary originally posted at www.speculative-investor.com on 10th July 2005.
Greenspan and many others have referred to the stubborn refusal of bond yields to budge from their generational lows in the face of Fed rate hikes and obvious signs of inflation as a conundrum. On the other hand, there has been no shortage of explanations put forward for this apparent conundrum, from Richard Duncan's theory that it is primarily due to the re-cycling of trade-deficit dollars by foreign central banks* to the notion that there is so much liquidity sloshing around the globe that all prices, including bond prices, are being elevated.
There is some truth to these explanations. For example, hundreds of billions of the dollars exported by the US in exchange for manufactured goods have been re-cycled back into the US bond market by foreign central banks; and over the past few years there has certainly been a glut of liquidity in the financial world. However, all of these explanations sidestep the real issue, which is that inflation expectations remain low. How low? Well, the difference between the yield on a 10-year T-Note and the yield on a 10-year Treasury Inflation Protected Security tells us that the market is presently expecting the US$ to depreciate by an average of only 2.3% per year over the next 10 years. Furthermore, Bill Gross, the manager of the world's largest bond fund, opines that inflation is going to remain low and that this will result in the 10-year interest rate remaining near its current depressed level for years to come.
With the effects of inflation becoming blatantly obvious over the past few years the conundrum lies in the persistently low level of inflation EXPECTATIONS, not in the associated low level of long-term interest rates (the latter is just a consequence of the former). The reason is that if the market were expecting the dollar to lose purchasing power at the rate of, say, 5% per year over the next 10 years, as opposed to the 2.3% per year that it actually does expect, then long-term interest rates would be substantially above their current levels REGARDLESS of how many trade-deficit-related dollars were being re-cycled by foreign central banks; or how much liquidity was sloshing around the globe; or anything else. And it really is a conundrum because large rallies in commodity prices have, in the past, ALWAYS caused inflation expectations to move much higher.
The key question can therefore be phrased as follows: Why have inflation expectations remained depressed in the face of a major rally in commodities?
Once again there are a few popular theories, one being that the low-cost manufacturing centres of Asia are expected to prevent the effects of inflation from spreading outside the commodity markets and another being that the bond market senses a serious deflationary threat. These explanations, too, contain some truth, but don't stand up to close scrutiny because anyone who pays the household bills will realise that the effects of inflation are widespread and anyone with more than a cursory knowledge of how the current monetary system works will realise that the probability of genuine deflation occurring in the foreseeable future remains very low.
We confess to not knowing the answer to the above question, but it's quite possible that the bond market is simply wrong and will be forced to make a big adjustment at some point.
The present bond-market situation and the theories being concocted to explain it remind us of the first quarter of 2000 when all sorts of explanations were conjured up to explain the tech stock phenomenon (why tech stocks were priced at such high levels and why they were destined to reach even higher levels over the ensuing years). The analysts who put forward these explanations looked smart for a while because although their arguments were mostly bogus their conclusions agreed with the price action at the time. As it turned out, the market's expectations were completely wrong and the NASDAQ lost 80% of its value over the following 2.5 years.
It is actually quite common for the market to get things completely wrong. The bond market has, after all, forecast 27 of the last zero deflations. The proclivity of the market to get things wrong is why large price moves regularly happen within relatively short spaces of time and why Warren Buffett was able to turn a few thousand dollars into 35 billion dollars (Buffett became incredibly wealthy by exploiting the chronic tendency of the financial markets to misprice assets).
Of course, just because an investment is over-priced at the moment doesn't mean it's a good idea to bet on a price decline because mispricing can persist for an inconveniently long time. However, it's always a good idea for a long-term investor to minimise his/her exposure to those investments that are very over-priced.
*Duncan's theory is based on the generally accurate view that foreign central banks -- mainly the central banks of Asia -- are far more concerned about maintaining the price-competitiveness of their exports by preventing their currencies from appreciating against the US$ than they are about obtaining a reasonable return on any investments they make. For this reason, many of the dollars that flow out of the US as a result of the trade deficit get purchased by these foreign central banks using newly-printed local currency and then get channeled into the US bond market. The theory is that because the central banks that are buying US bonds are price insensitive (they don't care whether or not the bonds offer a reasonable yield, they just care about preventing their currencies from strengthening), the larger the US trade deficit gets the greater will be the foreign official-sector demand for US bonds and the less likely it will be that bond prices tumble.
The Secular Trend for Bonds
Our view is that a secular bear market in US Government debt commenced in June of 2003, but while the following weekly chart of T-Note futures is consistent with this view it does not provide what we'd consider to be solid supporting evidence. In particular, it would be equally reasonable to interpret the price decline since the June-2003 peak as a large topping pattern (our interpretation) or a consolidation within a secular bull market (the interpretation of bond bulls).
However and as discussed at length in previous commentaries with regard to the stock market, secular bear markets are not about large declines in NOMINAL prices; they are about large declines in REAL (inflation-adjusted) prices. After adjusting for changes in the value of the US$, for instance, it becomes apparent that the 1966-1982 bear market in US stocks was every bit as severe as the 1929-1932 bear market, even though the earlier decline took the form of a collapse in nominal prices whereas the latter decline took the form of a flat consolidation in nominal price terms. Furthermore and as also discussed in previous commentaries, the best way to measure the real performance of a market over the long-term is to measure its performance relative to gold.
Looking at the performance of the US T-Bond price relative to gold since 1990, what we see is a long-term peak in the first quarter of 2001 followed by a major decline. In real terms, bonds have lost about one-third of their value over the past 4-and-a-bit years.
Further to the above we are very comfortable with our view that bonds are in a secular bear market, although it would be more correct to say that the secular bear market began in 2001 as opposed to 2003.
A good investment is one that provides a good real return, so T-Bonds were an excellent investment during the 1990s but have clearly been a bad investment over the past few years. Looking ahead, we think they will continue to be a bad investment because the actions that will be taken by the Fed and other central banks over the next several years are likely to be lot more bullish for gold than for bonds.