What’s Next for Bond Prices?

by Peter St Onge 

Today’s post is a bit more technical than usual, because I’ll be at Doug Casey’s Summit next week and want to get some thoughts out there.
One of the biggest questions for a 2014 asset manager is what’s next for bonds. The answer is both easy and hard: the easy part is that bond prices depend on inflation, since the Fed is obsessed with inflation and happens to controls bond prices.
The harder question is what’s next for inflation? There are two stages here. First stage is what comes out of the economy itself, “in the wild” so to speak. The second stage is how the Fed reacts.
Inflation, also known as the “purchasing power of money” is simple to track using every economists’ child-hood friend, the supply and demand graph. On this one “PPM” is purchasing power of money (keep in mind “down” is inflation and “up” is deflation”), the S=M line is money supply and the D line is money demand.




First stage “in the wild” inflation simply comes out of changes in these two lines: changes in money supply (S) relative to money demand (D). (If none of this makes sense yet don’t worry — my new book “Profiting from Business Cycles” that explains the cycle using Classico-Austrian theory is coming out, hopefully by Christmas).
Nowadays Fed Chair Yellen wants to lower the growth rate of money supply but she wants it to keep growing. Basically to “slow down” but keep driving pretty fast. So she wants S to keep moving to the “right” but not too quickly.
Recall that, even without QE (which raises money supply so S line to right), loan quantity is rising simply because interest rates are so low. Historically, anything under 5-6% real (inflation-adjusted) is generally inflationary, simply because 5-6% is about the “natural” human rate of interest. Meaning that anything below 5-6% real is like selling dollars for 50 cents; you’ll get “too many” borrowers. (“Too many” includes sub-prime borrowers, but that’s for another day.)
The other half of the “born in the wild” stage is what happens with money demand, D. This will depend mainly on economic growth, since a rising economy “soaks up” new money faster than a flat or falling economy. It’s actually more complex when low rates themselves are causing the growth; more on that below.
Meanwhile, any major drama that strikes fear into people (Russia invading Ukraine, ISIS invading Jordan, China invading Vietnam) will also raise money demand since people save more when they’re worried.
So, to ask what the “in the wild” economy will do, Yellen says that inflationary pressures will continue to build from the supply side, so inflation depends on the horse-race between that supply growth and demand growth from the growing economy and/or crises.
Part two is how the Fed responds. If growth keeps up then money demand should keep up with the still-growing money supply, keeping inflation benign. This means the Fed continues tapering, and we get the Goldilocks scenario: subdued inflation with decent growth.
What could screw this up? Two scenarios are most likely: either the economy does not grow fast enough to soak up the rise in money supply, or there is some drama that raises money demand. Or, the “black swan,” the economy grows too fast.
Slowing domestic growth would keep money demand growing slower than Yellen’s supply, leading to inflation. This could either happen because major export markets slump — Europe’s a prime suspect here. Or it could happen because regulatory burdens increase in the US. This last risk seems lower ever since the GOP won the midterm elections, ending the Pelosi-Obama regulatory festival. If anything, the GOP is likely to gain seats in the 2014 midterms; here’s hoping Washington “gridlock” keeps the regulations growing slowly.
For the crisis scenarios the three main sources of instability at the moment (September, 2014) are from Russia-Ukraine, the Middle East, and China. None of these should actually impact US economic growth very much: none are net importers of US goods. Meaning their instability might raise US domestic prices, but that alone doesn’t impact domestic inflation. The reason is that price rises in one area (say, imported oil) simply drains demand from elsewhere, lowering prices in that “drained” area. If Saudi oil gets dearer, for example, the money comes out of iPads or housing, which get cheaper. A problem for landlords, sure. But not for broad inflation and therefore not for the Fed. These crises’ main impact is instead on savings; more crisis means more deflation from higher money demand.
So, unless Obama shifts from short-term economically benign policies (like immigration reform) to short-term destructive ones (like carbon regulation), I wouldn’t expect major problems here.
Finally, a “black swan” risk for bonds comes, surprisingly, if the economy does “too well.” In this case, rising monetary demand from a growing economy gets swamped by a rise in circulating money supply as consumers and businesses pull money out of savings to spend it. In this scenario, dis-saving (especially of “excess reserves”) swamps the growth-related rise in money demand. Which can lead to high inflation.
In this high-growth scenario, inflation is likely to spook the Fed, causing a relatively fast ramp-up of rates. This would mark an inflection of the business cycle, as the sugar-mommy Fed drains the punch bowl. But keep in mind it takes awhile for asset prices to inflect. You’d probably want to keep hitting the punch bowl for awhile, but definitely start the “clock” on tapering your market exposure. I’ll get into the mechanisms and timing of that “clock” both in the book and in future posts.
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