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30 years ago there was little reason to buy bonds, yields in real terms were near zero and many experts only saw inflation going higher in the future. These conditions saw many investors pessimistic about holding bonds relative to other assets. Over the next 30 years, bonds have seen a spectacular rally along with the stock market, the best of any generation some believe. Now we are facing the same dilemma as those pundits did in the early 80s, only this time the market isn't able to get enough fixed income. It would be great if the market plays out the same as in the past, but the current situation will not produce the same results.

The U.S. is near the end of its leveraging cycle which saw bond yields drop below 2% on the 10-year treasury. Inflation waned over the years as interest rates continued to hit lower lows and lower highs through normal business cycles. This resulted in financing costs being a smaller burden on business, investors, and individuals; as a result more borrowing could occur to increase capital expenditures, leveraged investing, and personal spending. Now that interest rates are at record lows, the Federal Reserve has taken to adding money into the market through several asset purchase programs, known as QE. These conditions will stoke inflation and push real interest rates on treasuries into negative territory, the same fear market participants had 30 years ago. Unlike the past we can't rely on inflation to be tamed for the bond rally to continue; in fact, the Fed is comfortable seeing inflation higher than the current rate in order to avoid deflation. This opens the possibility for inflation to increase 20% or 30% over the current 10-year treasury yield by the end of 2013.

The 10-year treasury is currently yielding around 1.70%. Using long term inflation expectations as the required rate of return (RRoR), the 10yr is already trading at a slight premium (scenario 1), most likely due to recent concerns over the fiscal cliff. In these scenarios you can see the needed effect on treasury prices for the yield to keep up with inflation expectations. The first scenario is the current yield against the 12-month average inflation rate. Scenario 2 is the targeted rate of the Federal Reserve, should employment not pick up. And scenario 3 is the long term inflation rate of the US.

If scenario 3 occurs, longer dated securities such as the Vanguard Extended Duration Treasury ETF (EDV) lose as much as 30% of their current value. The spread between government bonds and higher risk assets such as corporate bonds was compressed last year in search of yield; these asset classes could also experience a sell-off. While there are plenty of factors that could cause a rally in the price of some fixed income assets, higher quality longer dated maturities will be the canary in the coal mine in terms of the erosion in return, adjusted for inflation. As you can see in the chart below, EDV was started near the end of the leveraging cycle and could see new lows, should inflation expectations start to rise.

(click to enlarge)

While the early 80s looked similar to this scenario, the bond rally occurring after 1982 was a result of taming inflation, and having bond yields drop alongside (but slightly above) the expected inflation rate. With the Fed looking to do just the opposite in the near term and the maintenance of our debt burden requiring yields to perform below inflation in the longer term, bond prices may have their best decades behind them.

Note on timing: With the US all but over the fiscal cliff it may be prudent to build a negative position over the first quarter or longer. Depending on how the talks proceed, the US may go into another recession which would in fact lower inflation even against the actions of the Fed.

Source: Double-Digit Drop For Bond Prices In 2013