The Coming Bear Market in Bonds

Includes: PST, SPY
by: NewstraderFX

On Friday, the Chairman of the Federal Reserve, Ben Bernanke, indicated that a radical shift in Fed policy had now taken hold.

Bottom line: Mr. Bernanke has a stated policy goal of increasing inflation in order to lower real short term interest rates and spur an increase in consumption.

According to remarks made by Mr. Bernanke last Friday at the Revisiting Monetary Policy in a Low-Inflation Environment conference in Boston, inflation is now running “at rates that are too low relative to the levels that the Committee judges to be most consistent with the Federal Reserve’s dual mandate in the longer run.” Please note that the phrase “too low” was published by the Fed in italics.

This take on inflation is very different from September, when, according to the minutes of the FOMC meeting [emphasis mine],

participants indicated that underlying inflation was at levels somewhat below those that they judged to be consistent with the Committee’s dual mandate for maximum employment and price stability.

The present ideology also represents a large difference in Mr. Bernanke’s thinking from his Jackson Hole speech on August 27, when he said that [emphasis mine]:

inflation has declined to a level that is slightly below that which FOMC participants view as most conducive to a healthy economy in the long run.

However, the biggest change pertains to the Fed’s view on deflation. Mr. Bernanke now believes that “the risk of deflation is higher than desirable,” an opinion which represents quite a change from the September FOMC meeting, where “participants saw only small odds of deflation,” after “analysis of the components of price indexes suggested disinflation might be abating,” and a complete departure from Jackson Hole, where he said that the risk of “significant further disinflation seems low.”

In his latest remarks, Mr. Bernanke acknowledged that nominal short term interest rates cannot be reduced further as they are “constrained by the zero bound,” which is another way of saying that Federal Reserve policy is now caught in a liquidity trap. Therefore, the Fed will now aim towards stimulating the economy by lowering real short term interest rates (which is the nominal rate minus inflation) with the only tool left in its arsenal-increasing the rate of inflation.

Essentially, Mr. Bernanke has acknowledged a problem I spoke about in a previous article (The Fed Is Creating A Deflationary Environment), where I said that as long as people believe that prices and interest rates will decline going forward (which is what I believed was happening as a result of Fed policy), they will delay their purchases.

Likewise, the new policy of creating inflation should stimulate aggregate demand because those who are able to buy will do so if they believe that prices will rise soon.

Market Implications of the New Policy

1. A bear market in fixed income. Once bond investors become convinced that the Fed is now dedicated to creating inflation and then decide to not “fight the Fed,” nominal interest rates will rise as investors sell their securities. We already saw a hint of this on Friday when the benchmark 10-year yield gained 5.2 basis points and the 30-year yield rose 6.4 basis points.

There are several options available to investors interested in this. For example, the Rydex Inverse Government Bond Strategy (RYJUX) inversely correlates to the price movements of the 30-year Treasury bond. A more aggressive play can be done with the Proshares Ultra Short 7-10Yr Treasury (NYSEARCA:PST), which is twice the inverse of the daily performance of the Lehman Brothers 7-10 Year U.S. Treasury index. Of course, traders need to be well aware of the risks involving leveraged ETFs.

2. A further rally in stocks as the dollar continues to depreciate. Dollar-denominated assets cannot appreciate in a vacuum; creating inflation means that the nominal prices of those items purchased with dollars will appreciate, which is the same thing as saying that the dollar has declined in value.

Some of the choices available to express these views include the The SPDR S&P 500 ETF (NYSEARCA:SPY), and you can short the dollar in the forex market by going long EUR/USD and AUD/USD.

Disclosure: Author is long EUR/USD, AUD/USD and RYJUX