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This is a quaint but somewhat outdated perspective, according to Peter Schiff.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 . . . 

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

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