The Bond Market and Inflation
David R. Kotok
June 12, 2013
“A knowledge of the laws of prices is essential for personal business success because every business transaction involves a guess as to the future of prices. Such knowledge not only is essential for the individual but also is vital for national stability. Many persons blame Congress, or the democratic form of government, or the organization of society based on private enterprise for the business collapse. These things are no more to blame for this collapse than they are to blame for the stalling of an automobile when the battery fails. If the battery fails, the thing to correct is the battery – not the gasoline, or the engine, or the grade of the road. If the exchange cog in our business machinery breaks, the thing to correct is that cog.
The individual has two tasks. One is to forecast the future of prices and conduct his affairs accordingly. The other is to inform himself and help in guiding public opinion so that national progress may be made. It is hoped that this book may help him in both respects.”
Prices, George F. Warren and Frank A. Pearson. New York: John Wiley & Sons, Inc., 1933.
The wonderful book from which the above quotation was taken was written in the Great Depression era. It was first published by Wiley in 1933 and reached its sixth printing in June 1934. That is the edition I have in my personal library.
Imagine writing a book about prices (inflation-deflation) in 1933. Europe was embroiled in post-Weimar inflation turmoil, and Hitler was coming to power. The US had elected Franklin Roosevelt to lead the country out of a depression and was devaluing the dollar in terms of gold. The Roaring 20s were ancient history, and the country was wondering if it could ever recover from the collapse of the American economic system. No one knew there would be another world war in only six or seven years. No one contemplated a German invasion of Poland (1939) or an attack on Pearl Harbor (1941).
The book talks about prices. It discusses commodities and currencies and falling prices and how to stabilize prices. It is jammed with data. The charts end with the year 1933. Some of them start with the American Civil War. Others include price-index construction dating back to the beginning of US official national history. The book was assembled before the US went off the gold standard and covers the period of time when money was gold and/or silver. And it talks about price change in those terms.
Lessons from this classic text are applicable today, including its references to distortions in markets. For the last few weeks we have seen bonds selling off viciously as a result of confusing communications from the major central banks. Bonds may be reacting to some changes in inflation expectations, but the inflation evidence does not support this view. In our opinion the bond market adjustment is too extreme and has created bargains in bonds.
We are seeing the very highest grade tax-free Munis yielding above 4%. Some trades are at 125% to 130% of the referenced long-term taxable treasury. That pricing is absurd. A taxable equivalent yield calculation for a highly taxed American investor is now above 7% and as high as 8% in certain states.
At the same time, inflation statistics are pointing to downward pressure on the price indices. Those statistics seem to be indicating tepid economic growth pressure and a rising risk of weakening in many economies around the world. There are signs of a fear of deflation risk appearing in markets.
If markets have overreacted and bonds are very cheap due to poor communication policies of central banks, then that presents a buying opportunity in tax-free bonds, and we will take advantage of it at Cumberland. We are now lengthening duration and widening some of the hedging strategies in our managed accounts. If the market wants to give us bargains, our job is to take them.
We will close with this wonderful gem from Prices:
If one had left an estate with a guaranteed annual income of $100 per year in gold in the United States or in England in 1873, and if the guarantee had been fulfilled, by 1896 the beneficiary would have had a purchasing power of twice the anticipated amount. This was due to low gold production.
If a similar provision had been made in 1896, the buying power of the income by 1913 would have shrunk to two-thirds the anticipated amount. This was due to finding large amounts of gold. By 1920, the added fact of low demand for gold would have cut the buying power to less than one-third of the anticipated amount.
If the investment had been made in 1920, and if the agency paying the dividends had not gone bankrupt, the buying power would have increased almost two and one-half times by 1932. This was due to low demand for gold for money in other countries, followed by high demand.
The instability is much greater than the above figures indicate, particularly when prices decline. If prices rise, the buying power declines but the agency which agrees to make the payment is likely to remain solvent so that some income is secured. If prices decline too much, the buying power of the income would be greatly increased if obtained, but the agency that agreed to make it would likely be insolvent.
David R. Kotok, Chairman and Chief Investment Officer