The bond market is no longer a reliable inflation indicator. Investors worried about depreciation of their assets should turn to the gold and oil markets to measure the S&P 500 in real terms.
The financial market used to be an accurate information system. Share prices used to inform about investors’ future growth expectations. Bond yields used to serve as a reliable indicator for inflation and creditworthiness. Remember the «bond vigilantes»? These were the bond investors who watched over price stability.
When monetary or fiscal policies had inflationary potential, they would short bonds in protest, which would increase yields. That was the liberal way for the market to sanction inflationary or irresponsible policies. Investors would take notice and look for safer havens. Governments or companies would be pressured into cutting back their excessive deficits. But that was before.
Now we have what we call the Fed put. It is the belief that the U.S. Federal Reserve (or the European Central Bank in Europe) will always intervene and rescue the economy and financial markets when needed. Concretely, the Fed will start by lowering interest rates at the short end of the curve, as it did this year, and then act on longer term rates if necessary. That explains why the 10-year Treasury rate has been below average for a decade and under 1% at the moment. Hardly a warning sign for inflation.
The Fed does this by stepping in and buying sovereign securities, but also corporate bonds as it did this year since March. That puts a floor under everyone’s feet. Actually, not everyone. «Bank lending conditions diverge strongly from the buoyant junk bond market», writes the Financial Times. The article titled «America’s two-track economy, the small business credit crunch» shows how a poor quality big company can easily raise 2,5 bn $ in the bond markets, whereas a high quality small company will struggle to borrow even 500'000 $ from a bank.
The «Fed put» means a crisis or a crash is potentially good news for the markets. In 2009 and 2020, Fed rescue programs created the best bull markets of the century. The result is that the bond market went from an inflation gauge to an inflation producer. It no longer follows old market principles (the main «buyer», the Fed, isn’t concerned by the profit dimension), but it mirrors direct monetary creation.
It invites you to borrow and invest, or miss out on the opportunity. To the point that if investors were to dump stocks or bonds, as they did in March of this year, the Fed would overturn them. Selling bonds against the Fed is irrational. So you stick to the QE schedule, and invest in bonds even without conviction, just riding the tide. Even when yields are that low, U.S. bond purchases continue. The bond market – including corporate bonds - is now perceived as a «sovereign asset» and rated as such, because of the central banks’ permanent backing.
A 10-year yield below 1% tells you that investors are ready to lend money to the U.S. government or to a corporation without much compensation for future risk of losing purchasing power. But wait before sweeping inflation aside. Has it vanished? Of course not. So where do we look for inflation signals, if we happened to care about sound money and have fallen into the Austrian economics pot early on?
The currency market could serve as a good indicator, but central banks all over the world are playing the same devaluation game, their currencies outbidding each other downwards.
The gold and oil markets are better indicators, because the Fed has much less influence over them. Gold prices have doubled since the Fed started its unconventional policies in 2009, which means you need twice as many dollars today as in 2009 to buy the same ounce of gold. The oil price has also reflected a lower dollar since 2009, compared to previous decades. The average annual oil price culminated at almost 110 $ in 2012. This year, at 40.50 $ per barrel, it is twice as high as in 1979.
If you remove the dollar factor and look at how many barrels of WTI you can buy with an ounce of gold, you will notice that the relationship between the two commodities has been remarkably stable since… 70 years. In March 1946, you could buy 30 WTI barrels with an ounce of gold. In November 2020, an ounce could buy 39.3 barrels. That means only a slight devaluation of oil relative to gold (which is recent and Covid-related).
What this all means is the purchasing power of commodities has remained relatively stable, if we factor currencies out. It is currencies that have devalued. Inflation resides in the value of currencies. Consequently, if the dollar is declining, investors should ask themselves if their stock gains in recent years are not just a reflection of the currency losing value, even if the nominal value is high.
We can check this by looking at the value of the S&P 500 in gold terms. The picture is eye-opening: You need half as much gold to buy the S&P 500 in December 2020, even at its nominal sky-high levels, as you needed in December 2000. So, in gold terms, the real value of stocks is lower today than in 2000. And in December 1960, it took the same amount of gold to buy the S&P 500 as today, six decades later. Sobering.