Bond Prices and Future Inflation and Deflation


Edwin Rubenstein and Peter Brimlow have just written an interesting article in Marketwatch in which they argue an examination of historic bond prices seem to indicate that inflation is a greater probability than deflation. This conclusion is based on a chart, which shows bond prices for the past 100 years compared to a regression line.

If you look at the chart, you'll see that bond prices are currently above trend. If you believe that prices will eventually revert to the mean, than bond prices have to come down and  yields go up (prices and yields move in opposite directions). Rising yields are usually an indication of inflation.

But what if there is another alternative here? What if we are going to enter a period in which rates and the economy part ways. Suppose the economy continues to sputter along but government debt continues to grow at alarming rates. It may require higher rates to finance the deficit. The deficit will crowd out private capital, requiring everyone from consumers to companies to compete harder for the remaining capital, raising rates in these markets.

The rise in rates further depresses the economy. A depressed economy with over $1 billion in idle capacity can hardly raise prices, resulting in low inflation.

The point of all this, is that it's possible to envision a scenario where bond prices fall to historic norms without the usual rise in inflation. The key will be not only bond pricing but unemployment and other macroeconomic indicators.

Sam Cass
Sam Cass: Sam Cass, MBA, JD, University of Texas at Austin. Always a fan of Leonardo Da Vinci.

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  • Arnold

    September 26, 2009

    The massive budget deficits are weakening the dollar. If the dollar goes down further or collapses that in itself will cause inflation as it becomes more expensive to import. Look at what happened to oil last year as the dollar fell. If the dollar really collapses then we could be in for a round of hyper-inflation.

    Either way, I think we are far from out of the woods.

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