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Current Bond Prices Reflect Inflation Fantasy not Reality

Current Bond Prices Reflect Inflation Fantasy not Reality

Last month, despite crude oil prices jumping 18% (one of the largest monthly increases on record) to reach nearly $44 per barrel, yields on long-term treasuries actually fell slightly. As there is typically a strong positive correlation between interest rates and oil prices, with both typically rising in response to increasing inflationary pressures, this divergence should be troubling. The key to understanding the phenomenon may be the fact that while oil prices reflect actual inflation, interest rates only reflect expected inflation. As such, the divergence is a clear illustration of how on Wall Street the divide between inflation reality and inflation fantasy continues to widen.

In fact, Wall Street analysts often point to high bond prices and low long-term interest rates as evidence that inflation is not a problem. After all, it is argued that future inflation is discounted into current bond prices. It therefore follows that if bond investors do not fear inflation, judging by their willingness to loan fixed dollar amounts for long periods of time at low interest rates, that there must be no inflation to fear. Putting aside the fact that current bond prices are being distorted by foreign central banks, mortgage related hedging, and speculators, bond prices reflect what buyers expect inflation to be, not what inflation actually will be.

As an example, NASDAQ stock prices in 2000 reflected not what future earnings would be, but rather what future earnings were expected to be. We now know, of course, just how overly-optimistic those expectations actually were. However, at that time, one could have pointed to high stock prices, as many often did, as evidence of how high future earnings would be. That conclusion was erroneous, as high stock prices merely reflected what stock “investors” hoped earnings would be. Similarly, today’s low interest rates reflect what bond buyers hope inflation will be, and the latter will likely be just as disappointed as the former.

In fact, investors seldom get what they expect, yet often get what they deserve. Stock “investors,” seduced by Wall Street “analysts” who blindly bid stock prices to ridiculous levels, on the anticipation of earnings growth, which common sense should have revealed impossible to obtain, expected to get rich, but became deservedly poor. Today’s bond buyers, blindly following Government and Wall Street propaganda, while ignoring common sense, will similarly fail to achieve anything near what they expect, but something much closer to what they arguable deserve.

If anything, irrational, hysterical, blind-optimism, on such things as earrings and inflation, coming at the ends of long-term bull markets, are great contrarian indicators. At the end of the 1982-2000 super-bull market in stocks, investor optimism on future earnings reached an extreme. At the end of the 1981-2003 super-bull market in bonds, it makes sense that benign inflation-expectations would also be equally absurd. In both cases, participants ignore what should be obvious, and instead remained firmly committed to the mantra of the preceding bubble; proving that while investor behavior may indeed be irrational, at least it’s consistent.

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