Will That Be Inflation Or Deflation?

The announcement in mid-March by the U. S. Federal Reserve Board that the mind-boggling sum of $1 trillion would be injected into the banking system over the next few months sent world stock and bond markets on an asset-buying spree.

Bond prices soared, driving down interest rates further — exactly as the Fed intended. Stock markets returned to life as bank stocks, including such casualties as Citigroup and Bank of America, doubled in price.

As I write this column, commodity prices are rising, energy prices are up, gold is again heading toward US$1,000 and stocks have taken a breather for a few days. There is no sense of foreboding. A recovery on Wall Street and Bay Street seems to be the belief of the market. Bond investors, a more sober lot than stock market speculators, are perplexed.

Interest rates have plummeted in the past year to low-single-digit values in all major G-7 nations. Canada’s overnight rate is 1.5 per cent, the U. K. overnight rate is 1.0 per cent and the U. S. Fed lends reserves to banks at zero per cent — zilch. Those are rush-to-the-lifeboat rates.

Meanwhile, the action of the Fed and the expected replication of massive cash injections by other G-7 central banks have sent interest rates down on long bonds — with disturbing implications. Let’s look at the mechanics of the Fed move.

The Fed will buy long treasury bonds from banks and other financial institutions that need its support. The banks swap bonds for cash that they can lend. Buying those bonds raises their prices and, as they rise, the yield — the ratio of the existing bond interest payment divided by the new price — will fall. The yield curve, which maps interest rates on bonds from 30 days to 30 years, will be pushed down at the long end.

The effect of raising bond prices at the long end of the yield curve is to signal that the bond market expects a lower rate of inflation in periods of 20 or more years. In this case, bonds become more valuable because there is less fear of erosion of purchasing power by inflation.

But there is a contrary result — a fear that the trillions the Fed and other central banks will add to the money supply in the process of lowering interest rates will trigger serious inflation in years ahead. That has the contrary effect of raising interest rates. In short, adding money to the money supply may have only a temporary effect of adding to banks’ liquidity. In a few decades, inflation could win out.

Thus the consensus of the bond market is that pumping trillions of dollars of purchasing power into major economies around the world will aid short-term recovery and produce long-term inflation. For evidence, consider the value of inflation-linked bonds such as Canada’s Real Return Bonds. There are a handful of issues, all are long dated and all jumped a significant 1.15 percentage points on the day of the Fed announcement.

That one day jump was more than half of the 2.0 per cent average of return of RRBs in the 2.5 months of 2009 and a contrast to the 14.3 per cent average decline of RRB portfolios in the six months ended Feb. 28, 2009.

WHAT THE RECOVERY WILL LOOK LIKE

We have come to a fork in the road. One way leads to continuing global recession and depression. The other leads to recovery. Capital markets are saying that recovery will win, but it will be an unusual and troubled recovery. The patterns look like this:

The U. S. dollar will cease to be the world’s best place to park money. Fears of inflation drove investors out of greenback and into loonies and Sterling and almost anything else on the day of the Fed announcement. In fact, the greenback lost five per cent of its value against a basket of six major currencies in the hours following the Fed’s announcement.

Bond prices around the world will continue to slump on the technical trading basis that a great deal of money chasing any asset will raise its price. Bloomberg, a major world financial service, reported on March 19 that European government bond prices soared following the Fed announcement. The expectation is that bond prices will continue to rise as money is pumped into the world economy. That makes money less scarce and, since interest is the price of hiring money, the process makes sense.

Hard asset prices should continue to rise. Gold measures the value of paper money. More paper money chasing fixed amounts of gold implies that gold will buy more paper. That is, that the value of gold will rise.

Ditto commodities. Copper rose strongly following the Fed’s announcement. We will probably see jumps in all commodities from iron to nickel to lumber with the strongest jumps on those commodities that are closely tied to the world economy and the weakest jumps in commodities that, like frozen orange juice, are weather related.

WHAT TO DO

For individual investors, the fork in the road creates a new dilemma. Just because central bank policy now

appears to favour more intervention with more money being pumped into long bonds does not mean that 20-to 30-year government debt is the right place to be. A technical market correction that pushes up bond prices does not mean that inflation is over. If anything, inflation is likely to be more severe. That implies that Real Return Bonds will offer a valuable haven. That’s why their prices rose and why, right now, they can be considered as part of a bond portfolio.

Conventional long bonds are having their future returns sliced away by central bank market moves. The U. S. 30-year treasury bond now offers a 3.57 per cent return to maturity. That is fine for an insurance company that can charge a premium on top of the bond return to folks who want a life policy. It is not enough of a return to cover the risk of future inflation for an individual investor. It’s a full one per cent per year more than the 2.57 per cent return to maturity on the conventional 10-year T-bond, but still, I would suggest, not enough for two more decades of risk.

Government of Canada long bond rates of 3.56 per cent for 30 years and 2.70 per cent for 10 years pose the same dilemma.

The best deal is senior bank debt. The financial systems of Canada and the U. S. are the focus of their respective central bank rescue policies. You can get five to six per cent on senior bank debt. Those bonds have become more secure as a result of what is, in fact, a remonetization of the banking system. The likelihood of a bank failure in Canada has grown more remote, both as a result of the implied policy of protecting any institution too big to fail and as a result of cash injections into the banking system. Bank lending should increase, bank profits are likely to rise and, true to form, bank share prices have been rising. The effect on bank bond prices is bullish and strong.

Andrew Allentuck’s latest book, “When Can I Retire? Planning Your Financial Life After Work,” was published by Penguin in December 2008.

About the author

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Andrew Allentuck’s book, “Cherished Fortune: Build Your Portfolio Like Your Own Business,” written with co-author Benoit Poliquin, was recently published by Dundurn Press.

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