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Why Bonds Are Not Dead And The Dollar Gets Weaker

  • Written by Syndicated Publisher No Comments Comments
    May 20, 2013

    There have been quite a few bold predictions, since the beginning of the year, that the dollar was set to soar and that the great bond bull market was dead.  The primary thesis behind these views was that the economy was set to strengthen and inflation would begin to seep its way back into the system.  Furthermore, the “Great Rotation” of bonds into stocks, on the back of said economic strength, would push interest rates substantially higher.

    While I have no doubt that at some point down the road that inflation will become an issue, interest will rise and the dollar will strengthen – it just won’t be anytime soon.  A wave of“disinflation” is currently engulfing the globe as the Eurozone economy slips back into recession, China is slowing down and the U.S. is grinding into much slower rates of growth.  Even Japan, despite their best efforts through a massive QE program, cannot seem to break the back of the deflationary pressures on their economy.  This is a problem that has yet to be recognized by the financial markets.

    The recent inflation reports (both the Producer and Consumer Price Indexes) show deflationary forces at work.  Wages continue to wane, economic production is stalling and price pressures are falling.  More importantly, there are downward pressures on the most economically sensitive commodities such as oil, copper and lumber all indicating weaker levels of economic output.  The battle against deflationary economic pressures has been what the Federal Reserve has been forced to fight since the financial crisis.  The problem has been that, much like “Humpty-Dumpty”, the broken financial transmission system, as represented by the velocity of money, can’t be put back together again.

    Velocity-of-Money-051613-2

    The weak level of economic growth, global deflationary pressures, demographic trends and excess indebtedness which derails productive investment are keeping inflationary pressures suppressed.  The chart below shows the Composite Inflation Index (CII), an average of the consumer and producer price indexes, versus interest rates.  With inflationary pressures turning lower it is highly unlikely that we will see interest rates rising anytime soon

    Inflation-composite-interestrates-051613

    Our long term view on the 10-year Treasury remains at 1%.  Despite the Federal Reserve’s ongoing efforts to inflate asset prices; such inflation is not translating to “Main Street” in the form of higher wages, increased consumption or higher standards of living. The Federal Reserve has often discussed that there are limits to monetary policy and they may have found those limits in its most recent endeavors.

    The same goes with the U.S. dollar.  With Japan engaged, on a relative basis, in a Quantitative Easing program twice as large as the U.S. on an economy just one-third the size, the suppression of the Yen has boosted the Dollar higher in recent months.  However, the deflationary pressures globally are likely to create a feedback loop on Japan’s effort to create inflation leading to a economic decoupling that creates a potential disaster in Japan.   This is the bet that Kyle Bass has made and anticipates happening in the next 24 months.

    Inflation-composite-USD-051613

    The chart above shows the U.S. Dollar versus the CII.  Historically, downturns in the composite inflation gauge lead to, not surprisingly, declines in the dollar.  Currently, the economic data is confirming that we are likely to see dollar weakness sooner rather than later.

    The bottom line is that the “bond bull market” likely still has a bit of life left in it. The deflationary pressures that weigh on the consumer and the economy are likely going to keep downward pressure on rates for some time to come as the Fed comes to realize that they have been caught in the same “liquidity trap” that has plagued Japan for a generation.  Those same pressures will also temper any “dollar bull market” for the foreseeable future as well.

    The real concern for investors, and individuals, is the actual economy.  We are likely experiencing more than just a “soft patch” currently despite the mainstream analysts rhetoric to the contrary.  There is clearly something amiss within the economic landscape and the recent decline in rates, the dollar and inflation are telling us that.

    Images: Flickr (licence attribution)

    About The Author

    Lance Roberts – Host of Streettalk Live

    lance robertsAfter having been in the investing world for more than 25 years from private banking and investment management to private and venture capital; Lance has pretty much “been there and done that” at one point or another. His common sense approach has appealed to audiences for over a decade and continues to grow each and every week.

    Lance is also the Chief Editor of the X-Report, a weekly subscriber based-newsletter that is distributed nationwide. The newsletter covers economic, political and market topics as they relate to the management portfolios. A daily financial blog, audio and video’s also keep members informed of the day’s events and how it impacts your money.

    Lance’s investment strategies and knowledge have been featured on Fox 26, CNBC, Fox Business News and Fox News. He has been quoted by a litany of publications from the Wall Street Journal, Reuters, The Washington Post all the way to TheStreet.com as well as on several of the nation’s biggest financial blogs such as the Pragmatic Capitalist, Zero Hedge and Seeking Alpha.
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