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In my opinion, the crisis and the sharp recession of the past two years and the subsequent rescue packages around the globe did not provide the necessary catharsis that recessions need to bring to economies. ~ George Athanassakos

I chose a recent article from the Globe and Mail for today’s Friday Food for Thought. This one is by George Athanassakos, a professor of finance. He has been wondering about what the rise in both bonds and gold means for a couple of years now and provides some updated insights in this article: Who Is Right? Bond Bulls or Gold Bugs?

Usually a rising gold price indicates that investors see inflation coming. Rising bond prices, and the accompanying lower yields, usually portend slowing economic conditions, or some degree of deflation. Can both be right? Which one will have the greatest staying power?

Inflation or Deflation?

Mr. Athanassakos believes that gold and bonds can’t both be right. His money is on gold. He does not, however, buy into the idea that gold is only rising because the U.S. dollar is falling. Rather, he believes that the fall in the greenback and the boost in gold prices are both consequences of expected inflationary pressures in the future.

That inflationary pressure will likely emanate from more quantitative easing. “Markets and economies around the world have become hooked on low interest rates and liquidity infusions.” When traders believe that monetary authorities will prime the liquidity pump by lowering interest rates or providing more QE, markets rally. When it looks like central banks might tighten monetary policy, markets throw a tantrum and central banks reopen the meth clinic.

Mr. Athanassakos is quite certain that central banks will continue to deliver the narcotics the market craves, driving down interest rates in the short term, but ultimately creating an inflation problem. He sees higher gold prices as a “reasonable reaction” to the deleterious effects inflation will inevitably have on financial assets.

It’s a Matter of Timing

I don’t necessarily disagree with the author of today’s article. I think there’s a decent chance that the scenario plays out just as he expects. But as I mentioned in my recent article on GIC strategy, it’s important for investors to answer two important questions:

  1. What was I thinking?
  2. What if I’m wrong?

Mr. Athanassakos clearly has question number one covered. But what if things don’t play out as expected? There are equally valid reasons why inflation may not be a problem for quite some time. Another recent article, entitled Bernanke to Repeat Japan’s Mistakes, made a pretty good case for why QE may not necessarily create inflation. After all, the Japanese, on the advice of a certain Princeton professor named Ben, have been following the Keynesian yellow brick road for about 20 years now and have yet to create any spark of inflation.

While it may seem obvious that continual money supply expansion would lead to inflation, we have to wonder how long it will take to do so given the Japanese experience. It’s possible that Mr. Bernanke could have just as much trouble getting the QE flint to spark inflation as the Bank of Japan. If that happens, then both gold bugs and bond bulls could be right for much longer than you would think. However, if markets begin to believe that the Fed will not ultimately create any inflation, gold could go down, perhaps precipitously.

What about Biflation?

You will recall that I recently wrote about the concept of biflation, which is basically an economic condition whereby we experience inflation in some sectors while others are flat, or even deflationary. We have witnessed this phenomenon recently, as commodity prices have soared while U.S. housing prices continue to fall.

Perhaps biflation is a good explanation for the apparent contradiction in the simultaneous rise of bonds and gold. Bonds are rising because investors see an economic recovery that is flaccid at best, while gold is rising because they believe central banks will try to fight deflation with everything they have, even if it means creating bubbles in sectors like commodities. So investors are equally afraid of the disease and the cure.

My 2 Cents

It would be easy to say that you should be invested in gold and other commodities if you buy the inflation thesis, but stick to cash and bonds if you think deflation will remain stubborn. But the debate is so much more complicated than that. Here are just a few of the questions I’m currently asking myself:

  • Gold has risen more than 500% over the last decade or so. At what point will Fed-induced inflation be priced in?
  • Everyone expects the Fed to comply with more QE. What if they don’t?
  • What if they do deliver on QE, but it doesn’t work? What if the inflation never comes?
  • What if QE only makes things worse by magnifying the biflation we are currently experiencing? The inflated sectors could form bubbles that pop even as the deflationary sectors continue to worsen.
  • There are still a number of anvils hanging over us out there. Any one of them could be an “all bets off” factor if it fell on us. I’m thinking about sovereign debt issues, and the U.S. housing and mortgage crisis that just doesn’t seem to want to go away.

I wrote about the foreclosure issue over a week ago when it was very sparsely reported in the mainstream media, but we are now seeing a lot more headlines pop up on the topic. It’s starting to look a little like the subprime crisis did in late 2007. If Mr. Bernanke tells us the problem is “contained”, that will be the cue to abandon ship. It seems many insiders have already done so.

I agree with Mr. Athanassakos on the need for a more thorough economic catharsis and structural financial changes. He made a reasoned, sensible case for buying gold, but so have the folks on the other side of the trade. That leaves me uncertain enough to maintain a heavy cash weighting in spite of the recent market melt-up. I haven’t heard anyone answer the questions above in such a way that makes me want to put my money where their mouth is.

Source: Can Gold and Bonds Both Be Right?