Who are you going to believe -- gold prices or the bond market?

We have previously argued that the Federal Reserve should declare victory and begin to signal that they will begin raising rates from the extremely accommodative target rates (essentially zero Fed funds rates) that they implemented during the financial panic.

The reasoning for our argument is simple: artificially low interest rates lead directly to long-term inflationary pressures which can wreak havoc on the economy (for further discussion see also this previous post and some of the resources linked within that post).

As longtime economist (now retired) Scott Grannis explains in a recent post on his illuminating blog, the Calafia Beach Pundit, warning signs of inflation are now clearly evident in several market-based indicators, including the decline of the US dollar against other currencies, the rising prices of commodities in general, and the rise in the price of gold in particular -- topping $1000 last week.

As he points out in that post, however, the bond market continues to glide along peacefully as if there is no danger of higher inflation on the horizon. When the bond market fears inflation, yields rise dramatically the further out you go on the curve -- reflecting the fact that a dollar you loan today that is paid back in ten years (for example) will be worth far less in terms of purchasing power due to inflation, and therefore lenders will demand higher yields to loan dollars for longer periods.

If longer-term yields suddenly snap upwards, the market price of existing longer-term bonds will fall drastically, because those existing bonds with lower yields will suddenly be worth much less than the newer bonds whose yields have been pushed upwards by the expectation of inflation. Thus, investors have to ask themselves which of these contradictory signals is correct -- the elevated price of gold (signaling strong inflationary pressure), or the relatively low yields of longer-term bonds (signaling a lack of inflation expectations from bond investors).

As Scott Grannis explains in his post, entitled "Why the bond market is so complacent," "The bond market has never been very smart about inflation, and neither has the Fed." The reason the bond markets are failing to signal inflation, in his view, is that they take their cue primarily from the Fed, and the Fed is not concerned about inflation due to their continued belief in the outdated "Phillips Curve" view of the causes of inflation. Mr. Grannis writes, "So the Fed is really the key. If the Fed is not concerned about inflation (and they aren't because of the Phillips Curve), then the bond market isn't."

We've written about the Phillips Curve before, and provided quotations from actual statements by Fed Chairman Ben Bernanke which clearly indicate that he is still in thrall to that outmoded theory, and to its related concept of the "output gap."

If you agree with Scott Grannis, as we do, and believe that the bond market is the one giving the false signal, then you should be very cautious about buying long term fixed-rate bonds right now. If he is right, then the bond market will have a serious correction when it finally recognizes the inflationary pressures that other markets, such as gold, have already picked up.

While these concepts are important for investors to understand and our views are geared towards guarding against an abrupt rise in interest rates, we would also conclude by arguing against trying to invest based on short-term "guesses" on the direction of interest rates, or currencies, or commodity prices. As we have stated many times in the past, such calls are not a reliable foundation for building wealth over periods of thirty years or more. Instead, investors should follow a consistent discipline of ownership of securities issued by well-run, growing companies. Doing so is the way most of the big fortunes in this country have been made.

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For later posts dealing with the same subject, see also:


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