How Inflation Causes a Top In The Bond Market

| April 11, 2008

Just yesterday I was sitting in a meeting.  Nothing new.  I seem to spend my days hopping from one meeting to the next.  I had the opportunity to meet with top management at a small mining company.  Their specialty is silver and copper and the business intrigued me.

As you know the commodity market has been white hot.  Just look at the chart below.  Despite the recent pullback, we are still near record highs in commodities.  The big debate seems to be if this recent pullback is the start of a downtrend or a pause before reaching new highs.

Why was I in this meeting?  I’m looking for something.  Sometimes I meet with management teams to gather fresh information about the company and their business prospects.  In this case I’m looking for information about the commodity markets.  I want to know how much longer this run to higher levels is going to continue.

But what really grabbed my attention was something quite unexpected.

Five minutes into the presentation I checked that I was in the right room.  Ten minutes into the presentation I looked at my schedule to make sure this was the meeting I wanted to be in.

You see, the first part of this presentation had nothing to do with commodities, or mining, or the business.  The first 20 minutes of the presentation was all about the economy.

That’s right.  They talked about the economy, the Federal Reserve, interest rates, and the US Dollar.  I was amazed.  In all my time as an investment banker we never started presentations like that.

Back in the day I coached CEOs and CFOs on how to arrange their presentations.  We went over how to speak, what to say, what to highlight, what words to use in the presentation.  I put their best foot forward – then shined the shoe.  Never, ever, did we lead off with a discussion of the economy.

Clearly times have changed.

Everyone these days is concerned.  Federal Reserve Chairman Ben Bernanke even uttered the “recession” word a few days ago.  Interest rates seem to be the topic of choice around the water cooler.  Just last week I overheard a discussion about the US dollar between a mini-mart cashier and a customer buying gas.

Like I said, everyone is concerned.

So what do we do?

We know we are in a recession.  We know the Federal Reserve is going to cut rates at the next meeting on April 30.  We know interest rates are going down, and the US Dollar is going lower.  But here’s an interesting thought . . . then what?

In a few months we’ll be through the financial markets mess.  The US economy will be showing signs of life and shaking off the recession.  The Federal Reserve will have cut rates to the bone – probably as far as they can.  The US Dollar will have set new lows. And inflation will be rearing its ugly head.

You heard me right. Inflation.

Inflation is here today, and we can expect more in the future.  Demand for commodities from emerging markets is high.  Just pick up any paper and read about the growth in China.  They are building infrastructure at a record pace (which requires commodities).  And these demands are going to continue for years to come.

The Fed is going to need to raise interest rates to combat inflation.  And one or two increases just won’t do it.  They will need to significantly increase rates, destroying the value of treasury bonds.  Remember bond prices go down when bond yields go up.  Once the Fed starts raising rates it won’t be long before we see a bear market in bonds.

This won’t happen right away.  It’ll be a few months before the prospect of further rate cuts are off the table and inflation starts to become painful.  If you have a portion of your portfolio invested in bonds I recommend keeping a close watch on inflation.  When inflation starts climbing the Fed will need to act.  That could signal a multi-year top in the bond market.

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Category: Bonds

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The Dynamic Wealth Report works with a number of staff writers and guest experts who specialize in everything from penny stocks to ETFs to options trading. These guest analysts post under the 'staff writer' moniker for ease of use.

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