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Does the Bond Market Have it All Wrong?

I have been fond of saying that the equity traders are the hormonal teenagers of the capital markets (traders think of markets as a daily version of Hot or Not?).

In our metaphor, the Bond market is the so-called adult supervision. Bond vigilantes have long been thought of as applying much needed pressure to the Feds to keep inflation under control, and rein in the deficit spending habits of the Federal government.

This is a quaint but somewhat outdated perspective, according to Peter Schiff. He writes that the Bond markets have slowly abandoned their responsibilities. Some recent changes amongst bond traders:

- they no longer focus very intently on CPI reports.
- they "admit" current signs of rising inflation are backward looking
- Yields are below Fed funds rate, despite inflation running at its fastest pace since the 1980's

How could this have happened? How could professional bond investors speed through these stop signs at 75 mph? Schiff states it happened step by step:

"The first step was convincing the markets that hedonic adjustments were okay. Next came the legitimization of substitution bias. Then the Fed convinced everybody to ignore monthly increases in food and energy. When that wasn't enough, it got everybody to ignore yearly increases in food and energy. Finally, when even all these tricks were not enough to conceal the growth of inflation, the Fed finally played its trump card by telling the markets that inflation is the poor step-child of its much more import parent, GDP growth.

This week, when the government reported better then expected PPI and CPI, data, the bond market went ballistic, as traders took the government's bait hook, line and sinker. Equities went along for the ride, and a good time was had by all. Lost in the shuffle was the renewed weakness in dollar, which has lost about 2% of its value relative to other currencies over the past month. The Fed pause has given currency traders the "all clear" to sell the dollar. Combine that with a poor technical outlook and I look for the dollar to meet with some intense seller pressure in the coming months."

His somewhat controversial conclusion? We can no longer look to the Bond market to determine if inflation is contained; Instead, the Smart Money is looking to the Forex markets, where the penultimate inflation gauge -- the value of the US dollar -- gets measured. 

"Since the value of the dollar is the single biggest determinate of prices, it is amazing that Wall Street can celebrate a victory over inflation based solely on one month's data despite the poor monthly performance of the dollar itself.. If the dollar continues to lose value, it's only a matter of time before sellers demand more of them in exchange for their wares. If they fail to raise their prices, the net effect is that they suffer a price reduction. So while Wall Street looks to the bond market as evidence that inflation is well contained, the smart money looks at the forex markets to realize just how much worse inflation is likely to get. Remember, bond yields do not reflect what future inflation actually will be, only what bond investor think it will be. Action in the currency markets will reveal just how wrong these bets are likely to be. (emphasis added)

Fascinating stuff, and  very consistent with my own inflation expectations . . . 

>

Source:
The Bond Market Has it Wrong
Peter Schiff
EuroPacific Capital, Aug 18, 2006
http://www.europac.net/externalframeset.asp?from=home&id=5867

Monday, August 21, 2006 | 07:09 AM | Permalink | Comments (59) | TrackBack (5)
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Comments

I think the bond market is still that responsible adult it used to be. Inflation was an issue a year ago when we did not make it an issue. Now we are trying to make it an issue, but it shouldn't be. Except for energy, most prices seem to be contained (or declining). Take SUVs. GM is practically giving them away, and will continue to do so as oil prices stay high. I noticed in Dell's monthly mailing, PC prices continue to decline. Home prices are declining now too.

It just seems to me that there is too much competition for too few dollars in todays economy to support inflation.

Posted by: Jack | Aug 21, 2006 8:04:52 AM

Yeah, Peter Schiff was the guy who was yelling at the top of his lungs at the start of 2005 about a Dollar CRASH. Crash my foot.

He was labeled by Forbes as one of the person who got the currencies market wrong completely.

I guess you must need a thick skin in this business and hope that people will forget your wildly inaccurate calls and then have the nerve to come back and tell the bond market that it is wrong.

Posted by: Anoynmous | Aug 21, 2006 8:21:18 AM

If the Bond market is priced on what inflation expectations are to bond investors , what do FX traders look at as a different indicator do judge what they think inflation is ?

Posted by: ThR | Aug 21, 2006 8:37:01 AM

DITTO AND DITTO...! Thank you...!

Posted by: albiegf13 | Aug 21, 2006 8:42:25 AM

the $ sell-off that Peter talks of - 2% this past month - is based on a few things : .... ECB , BofE , BofJ raising rates , making $ assets less valuable on a relative basis .... Fed not raising rates ...... economic #'s weakening ... these are all related to the different interest rate cycles in the US and the world .... the $ was up 2% in the previous month on the exact mirror-image of these events ... a month or 2 or more is not necessarily enough to make a judgement on

Posted by: spx | Aug 21, 2006 8:44:59 AM

i find it hard to believe that bonds traders base their decision on official CPI numbers. the quotes repeat well known facts. the truth is that there is demand for the gov bonds

Posted by: larry | Aug 21, 2006 8:55:50 AM

Fascinating. I wonder what Peter thinks about the other market based indicators reflecting lower inflationary expectations? For example, spot gold is making lower highs and has been in a downtrend since the Aug. 8 FOMC meeting. The TIPS spread has been basically flat since Aug. 8. And of course, treasurys have been screaming since well before the Aug. 8 meeting.

Maybe everyone in the $8.5 trillion treasury market blindly accepts the data manufactured by the bureaucrats at the BLS and the interpretation of that data by the 12 guys on the FOMC. But I doubt it. I think they have too much at stake and do tons of independent research to arrive at conclusions about inflationary expectations and set prices accordingly.

And I still think that if those treasury investors are willing to lend their money to the federal government for 5 years and only demand an interest rate of 4.75%, the inflationary expectations 5 years out of those investors is de minimus. He's right that the actual inflation will be different from the current expectations. But to say the current price/yield for 5 year treasurys doesn't incorporate the current consensus for investors best guess of what inflation will be 5 years out defies logic. He needs to offer a completely new analytical framework for valuing treasurys to make such an assertion.

Posted by: S | Aug 21, 2006 9:01:12 AM

I think we're entering long term trading ranges for Treasury rates and the US dollar. Look at a long term chart of the dollar...if you lop off the "outlier" of the '90s bubble, the dollar has entered the longer term comfort zone.

Bonds have a similar feel to me...I expect to see rates stabilize and range between 4-5% long term.

This is certainly not concensus.

Posted by: ss | Aug 21, 2006 9:09:24 AM

It doesn't make much sense to compare the current bond market to the bond market of 10 years ago when the bond market vigilantes were still alive.

Today the bond market is dominated by hedge funds and foreign central banks.

Hedge funds are leveraged and so don't care directly about inflation. Their primary focus is financing cost which is why they manically focus on Fed moves.

Also foreign central banks buy treasuries to fix their currencies to the dollar and US inflation isn't their main focus and objective.

So I wouldn't read too much into the message the bond market might be sending.

Posted by: Fullcarry | Aug 21, 2006 9:39:12 AM

I have to agree with Schiff. So what if he made a bad call, has no one here ever made a bad call? The fact is that the Fed is running a huge confidence game. The fools have bought into it hook, line and sinker.

Making people believe that there are 'deflationary biases' in the markets is how the Fed justifies printing $$ to maintain this ponzi scheme finance economy of ours. My vote is with Schiff, Fleckenstein, Saville and Ritholtz...there IS inflation, ask me about my school books, my gas, my grocery costs, my electric bill, my tuition etc...they are all UP!

Posted by: dukes | Aug 21, 2006 9:45:32 AM

I believe Peter is too married to a particular outcome. The bond market may just be telling people things aren't like the 1970s. The outcome is easier to predict than how we get there. One of these days, when I feell like writing a two thousand word essay, I'll lay it my worthless opinion similar to everyone else's worthless opinion. lol. Maybe next weekend.

If I had Viavoice, it woudl be done.

Posted by: BDG123 | Aug 21, 2006 9:56:31 AM

I once made a bad call once (lol)

More than once . . . I'lll estimate it at about a million times .

Posted by: Barry Ritholtz | Aug 21, 2006 10:11:43 AM

«And I still think that if those treasury investors are willing to lend their money to the federal government for 5 years and only demand an interest rate of 4.75%, the inflationary expectations 5 years out of those investors is de minimus. He's right that the actual inflation will be different from the current expectations. But to say the current price/yield for 5 year treasurys doesn't incorporate the current consensus for investors best guess of what inflation will be 5 years out defies logic.»

Unless the guesses are wrong, or the bond markets have switched to relative instead of absolute returns too, or the demand for bonds from institutions is unstoppable.

Or all three :-).

If you got long term institutional money to invest, what do you do nowadays? There is so much cash going around that a lot of it goes into bonds.

Posted by: Blissex | Aug 21, 2006 10:20:55 AM

I actually liked your comments this weekend in Barrons, Barry.

I love to hear more on your view of the oil markets (crowded longs) with storage capacity approaching 100%....we could see some huge pain in the commodity markets soon (watch the CRB). While energy shares would be a damper on the market, the key would be where that $$ goes...I see tech and finacials as the liquidity sponge in this regard. Transports are over sold as well.

Posted by: ss | Aug 21, 2006 10:23:11 AM

«Bonds have a similar feel to me...I expect to see rates stabilize and range between 4-5% long term.»

This is a very bearish sentiment :-). Because a nominal 5% implies either that real rates stay near zero as they have been for the past 10 years, and then inflation is around 4% long term, or that inflation goes back to 2% or less, and then real rates triple.

The past ten years have been based on free money and low inflation. Rates at 5% cannot be compatible with both...

Posted by: Blissex | Aug 21, 2006 10:26:27 AM

It should not be too surprising that Oil storage capacity is extrememly high right now. Commodity hoarding is a classic symptom of inflationary times.

People rather keep their wealth in Oil than Dollars.

The big surprise is why Oil producers keep pumping Oil even though they are flush with dollars and don't need any more of them.

Posted by: Fullcarry | Aug 21, 2006 10:29:01 AM

"then inflation is around 4% long term, or that inflation goes back to 2% or less, and then real rates triple."

I don't follow you here at all...I expect over the next few years to see another leg of (tech spending led) productivity that will put the nail in many long term inflation thesis. I recognize this is a minority opinion!

Posted by: ss | Aug 21, 2006 10:34:52 AM

..and if his bad call was a bearish dollar call, the $/Euro is down, what, 5% since last summer? That's no crash, but hardly the Worst Call Ever. And the current account deficit hasn't gotten any prettier. Perhaps all he had wrong was the timing.

On the bond market, what you want to look at are current-account-surplus country reserves. The Chinese and Saudis are putting them somewhere.

That said, on inflation as separate from the dollar, this is one subject on which I tend to buy PIMCO's current argument rather than Barry's. Like us, PIMCO sees a housing market slowdown impacting growth. Unlike Barry, they see this rallying US bonds. [BR -- And that differs from me how???]

For the moment I am still agnostic, since I see a risk, however small, that an exodus of oil-and-exporter money prevents treasuries from moving up the way they normally would in a slowdown.

Posted by: wcw | Aug 21, 2006 10:34:54 AM

these 2 markets are not incompatible but complementary of each other :
if inflation slows , if housing falls , then the Fed will not have to raise rates ---so bonds rally .... and the $ will slip as its relative interest rate value to other countries FX will be less

Posted by: jl | Aug 21, 2006 10:42:17 AM

I'd have to agree with Blissex.

I think the problem with the bond markets is the same problem with all the markets. The fed is printing too much money. I think most of the bond money is flowing through pension funds as boomers begin to save madly for retirement and pension funds have few places to put their excess cash.

All that cash is thus driving up the price of bonds and forcing down yields which is making the 'adults' look downright dopey. That is probably exactly what the fed wants.

It would appear fiat money is the opiate of the masses(and the bond market!)

Posted by: DavidB | Aug 21, 2006 10:44:05 AM

What's the opposite of "fiat money"?...that term always crack me up.

Posted by: ss | Aug 21, 2006 10:47:39 AM

How rational is it for dollar holder to sit tight while the Fed devalues the dollar again after the housing bust?

Are we to assume that dollar holders aren't rational and didn't learn anything from the Tech bust in 2000.

This is why inflation and inflation expectations are now structural. In fact one could argue that inflation will have a tendency to accelerate on fears of a US slowdown and Fed accomodation.

Posted by: Fullcarry | Aug 21, 2006 10:49:07 AM

Well I know Don Hays is not well thought of here, but I found it very interesting that in his missive today, he highlights his Bond Momentum indicator..this comes from the "Coppock Momentum Formula". When the chart crosses the -100 line, it has given a buy signal
(lengthen maturities). It has been correct EVERY TIME in nailing a bull bond market for the last 25 years.

Posted by: ss | Aug 21, 2006 11:09:41 AM

Jack: How many cars and computers do you buy over the years (or perhaps per year)? I bought my latest (respectively) 5-6 years ago, and I plan to hold on to the car for another 5 years unless I see a very compelling case to purchase a hybrid or whatever else more fuel-efficient they come up with, while I'm entertaining the thought to buy a new computer sometimes soon, but if in doubt will keep my current one until it gives out.

Based on those depreciation schedules, as a rough estimate I alone spend more on food than both car and computer combined. That excludes car maintenance and gas. My wife eats too, and we don't have another car. And every once in a while we go to the doctor, and even with our supposedly good medical/dental plans that costs us a bit.

Posted by: cm | Aug 21, 2006 11:12:39 AM

I agree with the comments above citing foreign central bank, carry trade, current account/trade deficit and global monetary growth issues as being culprits in shifting signals from the bond market. The bond market now tells us less about inflation because the market composition has changed, the motives of market participants have changed and the international monetary, exchange and reserve systems have changed dramatically.

Posted by: JS | Aug 21, 2006 11:14:50 AM

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