How Inflation Causes a Top In The Bond Market
The Dynamic Wealth Report
April 11, 2008
A Top In The Bond Market?
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.
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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.
• Delta Airlines (DAL) and Northwest
(NWA) received an upgrade from Credit Suisse this week. The
prospect of airline mergers are driving these ratings changes.
• Arch Coal (ACI) received a downgrade from HSBC this
week. The downgrade comes in the face of rising coal prices.
• Needham initiated coverage on Research in Motion
(RIMM) with a hold rating. They believe that rapid growth could
slow in future quarters.
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