Inflation, Deflation and Reflation at Once

Just imagine – two things you think can’t possibly happen together suddenly happen together.

Say like Coca Cola re-launches New Coke, but people actually like it. Would that mean the laws of physics had been repealed? Or would you need to change what you think…?

“Gold and bonds do not usually go up or down together. But try telling that to the markets over the last two months,” writes Mark Hulbert at MarketWatch.

“Since early August, in fact, gold bullion has risen by around 10% and the Treasury’s 10-year yield, which moves inversely with Treasury prices, has fallen by nearly 15%.

“These moves are substantial, in other words, and more than just day-to-day noise in the data. What’s going on?”

Put another way, “If the gold price is so high, why are 10-year Treasury yields so low?” asks a columnist at EuroWeek, the capital markets newspaper.

To repeat: Rising gold says people fear inflation. Or so both Hulbert and EuroWeek reckon, along with pretty much the rest of the planet. But inflation fears would mean rising interest rates and falling Treasury bonds…and that’s the very opposite of what’s actually happening to government debt.

“Either way you look at it then, recent trends are unsustainable,” says Hulbert. “Something’s got to give” apparently. And it won’t be his assumption that gold and bonds shouldn’t rise together.

“If central banks take the punch bowl away at the wrong time,” says EuroWeek, “those who have bought Treasuries will have been on the right track and we will face deflation. Whereas if they let the party go on for too long the gold hoarders will have been right…and we’ll be wheeling our cash for bread around in wheelbarrows.”

The key assumption that makes these two things impossible, of course, is that gold only goes higher on strong inflation…a demonstrably idiot claim given a quick glance at the 1930s. Or this decade’s four-fold gains. Or the 50% surge of fall/winter 2008.

Back to gold in a moment, however. Because while bonds say deflation, “Equities say reflation” as the Pragmatic Capitalist notes, together with David Rosenberg at Gluskin Sheff and pretty much everyone else. “The stock market is telling a very different story from the bond market,” TPC explains, and “unfortunately for equity investors, they have a poor record of forecasting the future when compared to bond investors.”

Yet again, these two things “don’t typically rise alongside” each other. Yet stocks have risen more than 11% since mid-June, while the 10-year Treasury yield (which moves inversely to bond prices, remember) has dropped nearly 0.7%.

“There have been 4 famous cases of such bond and stock divergences in the last 20 years. The most famous is the summer of 1987. We all know what occurred then.  The other three cases were fall ’94, summer ’98 and winter 2000. All three preceded declines in the market. Of all 4 instances, three of them preceded 15% declines in the S&P 500.”

Now throw in rising gold prices, and we’ve got rising stocks…rising bonds…AND rising gold. Hell, since Wednesday this week they’ve even pulled back together, too!

Is the moon made of cheese or what?

The curve-ball in all this – or so we guess here at BullionVault tonight – is not gold, nor stocks, nor even bonds. It’s the underlying guess-work, intuition, assumptions.

That gold only rises when the cost of living soars…or bonds only rise when stocks go down…or that a flood of money, created at zero per cent rates, can’t drive all things higher together, even the promise of cash redeemed in the future…lapped up by a pensions and finance industry faced with $11 trillion in Treasury-debt supplied, but a central bank vowing to step in if buying fails and cap any rise in rates.

Because right alongside, hedge funds are buying futures and options with virtually free finance. What’s not to love in this über-Reflation Rally redux…?

Adrian Ash

October 21, 2009