There are generally two investment models that investors employ when making investment decisions. The first is the equilibrium model, which states that investors are rational and prices will gravitate towards an equilibrium price given all the information imputed into the markets. This is the investment equivalent of Adam’s Smith’s “invisible hand” that describes the natural force that guides free market capitalism through competition for scarce resources.
The other investment model is the agency model, which is similar to a weather forecasting system where numerous individuals with different sentiments colliding together form not only pleasant weather (favorable capital markets) but severe weather (financial crises).
So one system assumes investors are always rational and the other states that investors are and can be irrational. This isn’t even a “jump ball." We have booms and busts because investors become irrational at the fringes, i.e. periods of fear and greed. One doesn’t have to look far for irrational behavior in the silver markets to support an agency-based model.
Irrational Treasury Prices: This is the case of U.S. Treasuries. Given the data available that includes a moderate economic global recovery, rising inflation and the prospects of the termination of QE 2 — as the Fed withdraws its $600 billion of purchasing power to the U.S. government debt markets — it should lead a rational investor to conclude that interest rates are likely to rise and the value of treasury debt will likely fall. So far, this hasn’t been the case.
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Widening Spread: The chart compares the month-over-month change in the annualized CPI versus the yield of the 10-year treasury constant maturity. The widening spread between the yield on the 10-Year Treasury and the CPI indicates other valuation factors at work, as interest rates typically track inflation.
However, U.S. Treasury prices have been driven higher (yields lower) as investors gravitate towards these debt instruments in times of political turmoil and economic uncertainty. The irony is that the S&P rating division has attached a "negative" outlook to the United States' AAA credit rating. There is a one-in-three or better chance that it will downgrade it if the U.S. does not get its fiscal house in order, and quick. A look at the U.S. debt clock would give investors a sense of the magnitude of this task. Throw in looming exhaustion of Medicare and Social Security, and you’ve got a mountain of debt to tame.
Never Bet against Marginal Investors Being Irrational: Therefore, based on an equilibrium model, long Treasury yields should increase (prices decline) as it is a rational conclusion based on the fact pattern. However, based on an agency model, irrational participants will likely continue to buy Treasuries on any sign of instability — although they should be buying the debt of more stable countries and shorting U.S. Treasuries. (The latter strategy has been like painfully waiting for Godot.)
One should never bet against the irrational investment decisions at the end of an asset cycle ... although the music will end, as it did for silver.