I don’t think I am going to take the first bet, but I’ll definitely take the second.
Your presentation was fine. As a matter of fact, your writing and and knowledge of the markets have improved dramatically over the last few years. However, you have a tendency to support you arguments, and draw conclusions, from miscellaneous “headline” facts that often belie the big picture, represent only part of the picture, or contradict reality.
While the economies of emerging nations are breaking out and almost constitute half of the global economy, they are not demanding “a similar lifestyle afforded to Americans.” In fact, the economies of emerging nations are geared to produce for export, not internal consumption. Western style consumption is actually antithetical to emerging countries’ cultures. Conversely, developed nation consumers are maxed out because of too much debt. It is this lack of global aggregate demand, resulting from too much debt in parts of the global economy and not enough in others, that is the essence of the problem and the reason treasuries continue to rally.
While Germany’s economy may be experiencing an uptick, it shouldn’t be a surprise. Germany has the least amount of debt, and historically, the strongest economy in the eurozone. Unfortunately, the rest of Europe is still in the midst of a deflationary drag, and there are serious questions about the very makeup of the eurozone, and the financial stability of its banking system. Therefore, in Europe we’re unlikely to see any signs of inflation over the next few years.
Japan faces similar problems as the U.S., however their problems pre-date ours, and their susceptibility to inflationary concerns lags behind ours.
Will the bond rally last forever? Of course not. Is it ending anytime soon...doubtful. Inflation is a lagging indicator of the economic cycle; it takes a while for inflation to turn in either direction, either up or down. It’s not uncommon for inflation to ramp up a year or so after the economy recovers, and I don’t think you will see that happening till the latter part of 2011.
When the bond rally does come to an end, will it be because of one of the reasons you enumerated? (“ inflation do to external pressures, an improving domestic economy or investors demanding higher yields for greater risk” ) Most likely it will be a combination of factors that first brings about inflationary concerns, and the first reason you mentioned may be part of the problem. Higher prices for the goods that the developed economies import from emerging countries could either cause in part or exacerbate existing inflation. Higher wage demands from emerging country workers, combined with devalued currencies of developed countries would lead to higher commodity prices. In fact, we are experiencing higher commodity and crude oil prices, and a weakened dollar currently.
Demand based inflation due to economic growth may be exacerbated by capacity constraints as economies start to recover, leading to the possibility of higher inflation. However, the “new normal” appears to be a reality. Slow growth in the developed world, insufficiently high levels of consumption in the emerging world, and seemingly inexplicable low total returns on investment portfolios, bonds and stocks. For now, there is plenty of excess capacity and the money supply is still shrinking. Even if money supply were to begin to grow, it would take a year or two until it’s inflationary effects were felt on the economy, so I don’t think you will see demand based inflation, from an improving economy for a while.
In a risk adverse environment, yield loses importance, and safety and liquidity become a paramount priority. We are seeing that currently. Historically low yields, yet they are still buying treasuries, (and corporate debt for the yield) because of their perceived safety. Investors are content to buy short dated maturities, and are not venturing out the curve in search of higher yields.Demanding a higher a yield for investments does not cause inflation, inflation cause investors to seek higher yields, in search of real returns. ,
More likely, the cause of the next bout of inflation will be caused by the actions of central banks or governments and then exacerbated by higher commodity prices, and supply demand imbalance due to capacity destruction. Central banks may be too late in reigning in extraordinary accommodation or may even feel that another QE is necessary. Finally, some governments will be tempted to use inflation as a solution to fiscal deficits during an era of low real growth. If a country doesn't see an easy way to grow out of its budget deficit, it could adopt inflationary policies such as debt monetization or currency devaluation as ways to solve its budgetary problems.
