Rosenberg: The Case For Bonds

This is just in from David Rosenberg:

In the discussion about the outlook for U.S. Treasury bonds, the point must be emphasized that supply alone has been an inadequate focus for predicting future price/yield. You don’t have to do much more than to go back to examples like these: the 30-year Treasury bond yield went from 4.7% to 6.7% in 1999, even though bond issuance by the Treasury was practically nil. And, the decline in JGB yields over the last 20 years, even though deficit spending has been spectacular in Japan and debt-to-GDP is approaching 200%. The last I saw, the 10-year JGB yield was at 1.2%.

The problem with trying to assess either supply or demand in the current market environment is that everything is so confusing in the early stages of this new secular paradigm of a global credit collapse. There is no way to get it completely right. As Lacy Hunt has always maintained, it makes much more sense to assess the outlook for inflation as the primary effort in predicting Treasury rates. Simple and elegant. Maybe perhaps instead of inflation, we should really be discussing deflation, which has emerged as the primary trend, and governments have few bullets left in the chamber to deal with it.

Bond yields have been low for some time, and they will remain low. But don’t be lulled into numerical micro-phobia (the fear of small numbers that plagues the bond bears). The near 30% slide in the Chinese stock market suggests that we have three to six more months of deflating commodity prices. And, if the trend in Japanese, German and Swiss yields are any indication, bonds in the United States and Canada have plenty of room to fall further.

This is exactly right, especially if riskier asset classes fall as earnings expectations are reduced as the global economy slows. A lot of investors have been anticipating the demise of US Treasuries or British Gilts for quite a while. Yet, even with inflation well above the Bank of England’s target rate, yields remain low. Rosenberg continues with his bond –bullish case with some words about bond cycles and deflation and some interesting historical context. Note, Louise Yamada believes that we are nearing the end of the secular bull market in bond yields. See Yamada: Ready for a bond bear market?

I was at an event recently where I was able to see two legends among others – Louise Yamada and Gary Shilling. Louise made the point that while secular phases in the stock market generally last between 12 and 16 years, interest rate cycles tend to be much longer – anywhere from 22 to 37 years; and she has a chart back to 1790 to prove the point! So while all we ever hear is that this secular bull market in bonds is getting long in the tooth, having started in late 1981, it may not yet be over. After all, the deleveraging part of this cycle has really only just begun and if history is any guide, it has a good 5-6 years to go – at a time when practically every measure of underlying inflation is running south of 1%.

Gary not only ran with a terrific chart showing, over time, the gap between aggregate supply and the inflation rate (talk about compelling), but a table showing (and this one goes back to 1749!) how the primary trend during peacetime is one of deflation and in wartime it is inflation (including the Cold War).

Expand your horizons and go back before 1945 and you would see that during the American Revolution, inflation averaged over 12% per year, to then be followed by 28 years of peace that coincided with deflation of nearly 2% annually.

The War of 1812, which really lasted four years, saw prices advance at nearly an 8% average annual rate, while the next three decades of peacetime saw prices deflate by 2.4% per year.

Prices surged at a 15% annual rate during the Civil War and then we went through 51 years in which the price level fell at a 0.7% annual rate. So looking back over the past three centuries, we have had 92 years of war and prices rose at an average annual rate of 6%. Gary goes on to show that when we are not at war, prices typically decline at a 1.2% pace (wars lead to government procurement policies and soaring demand for material that goes into the munitions process).

This is important because while fiscal policy may have a 40% correlation with the direction of bond yields, inflation is twice as important.

The bottom line is that those making a simplistic supply and demand argument about bond yields should concentrate more on inflation. In fact, Rosenberg believes inflation is the defining factor and I would agree. That’s not to say higher inflation isn’t a risk over the medium-term. It is. But deflation is still the greater risk for now.

Source: Breakfast with Dave (pdf), David Rosenberg, 22 Jun 2010