Last week, Ben Bernanke's helicopter flew into town and announced that QE3 was on the way. The previous two QE's have not resulted in much inflation but that might be in the process of changing. For years we at Pring Turner have maintained what we call the "Ultimate Inflation/Deflation Relationship," the relationship between gold (inflation) and bonds (deflation).
A few months ago the relationship completed a head and shoulders top and looked as if deflation was going to reign. The gold bond ratio completed such a formation by breaking below the red line, known as a neckline (see Chart 1 below). That action suggested that gold had begun a period of under-performance against bonds, probably lasting a year or more.
However, a funny thing happened on the way to the deflation party as this relationship refused to continue to the downside. To us this is the first sign that a pattern is going to fail. The second signal is a break back above the neckline and the third is move back above the line joining the head with the right shoulder. When that final signal materializes (which it has for this relationship) the odds favor the head and shoulders pattern failing.
The rationale goes something like this. The downside break in the Ultimate Inflation/Deflation Ratio implies there are likely a lot of investors who were short inflationary positions. When prices surprised them by moving back above the two trendlines in Chart 1 it means they are underwater on their trade and are now motivated to cover those positions. At the same time, others look at the situation and speculate an inflationary outlook is more likely. Thus we have some folks caught on the wrong side of the market and others who want to get in on the other side of the trade. That's why a failed head and shoulders pattern is often followed by an above average move in the opposite direction. Keep in mind, market prices are determined by the attitude of investors to the emerging fundamentals rather than the fundamentals themselves. People can and do change their minds and so do markets. This appears to be the case here.
So should you be avoiding bonds entirely? Not necessarily, because the Ultimate Inflation/Deflation Ratio only monitors relative performance. For the record, the ratio bottomed in 2001. In the intervening 11-years both assets rose in absolute terms, gold just happened to appreciate faster.
However, (Chart 2 below) shows, to borrow a well-known phrase "this time it may be different," because the secular bull market in bond prices might be on its final legs. In fact, bond momentum has reached the same level in an opposite sense as it did at the 1981 secular, or very long-term, trough in prices (peak in yields). A perfect swing of the bond pendulum if you will. Bond momentum also reached similar levels in 1986, 1994 and 1999 and declines in bond prices followed in each instance.
Time will tell of course, as it always does. However, the ratio between gold and bonds is giving us a strong message that this time the effects of the latest Fed bond buying spree will result in greater inflationary conditions than is generally expected or desired.