Why rising inflation will trigger a bond market rout

In bailing out the US housing and banking sectors with a huge monetary injection the Federal Reserve has released the genie of inflation. Goldman Sachs sees oil prices of $150-$200 within the next 18 months as a result. And if inflation gets out of control central banks will have to raise interest rates and even a whiff of that possibility will mean a big sell-off for bonds.

Sunday, May 18 - 2008 at 13:59

For who will want to hold US treasuries that are falling in value as well as paying low interest rates in a depreciating currency? The risk of a rout in the US treasury market is therefore a very real one.

This would have a highly damaging impact on the balance sheets of global central banks which have huge amounts stashed in so-called safe US treasury bonds. There has already been a gradual shift out of these dollar-denominated assets in response to the devaluation of the greenback.

But in a real bond crisis that trickle would become a flood. Bond sellers would be buyers of higher yielding currencies, quasi-money assets like gold and silver as well as hard assets in the form of commodities from energy to food.

Terrible investment

The problem is that as Dr Marc Faber argues bonds could well prove to be currently the worst value as a major asset class in 30 years. They pay a miserable return in a devaluing currency and are highly vulnerable to capital value erosion through inflation.

Indeed, the way the market works ensures a rapid re-pricing of bonds depending on inflation and interest rates, which will have to be adjusted to dampen inflation. If inflation goes up the market begins to anticipate higher interest rates, and so the price of bonds goes down.

Hence if inflationary prospects are judged to have significantly risen, then the risk to bond prices is obvious. And why hold an asset class that is going to fall?

That inflation is rising around the world is so blindingly obvious that it is not necessary to quote statistics, most of which are exceedingly misleading as they remove items like food and energy. Oil at $128 a barrel is both highly inflationary and a symptom of inflation in the system.

Fed policy

But let us not forget what caused this inflation. It has been a deliberate policy of the Federal Reserve to pump money into the system to offset the impact of the housing crash and banking crisis. Unfortunately the well known side-effect of loose monetary policy is inflation, and pumping in more and more money produces more and more inflation.

That brings us back to the US treasury market. How long can bond prices hold up under pressure from inflation? It is clearly not easy for central banks to all sell their treasuries simultaneously and buy euros or gold instead.

Yet bond markets will have to re-price for higher inflation – and that higher inflation is on the way ought to be obvious and is probably why the US stopped publishing its M3 money supply figures over a year ago. So get ahead of the yield curve and dump US treasuries for a more defensive asset class. This could all get very nasty before its gets better