John Maynard Keynes once famously said:
“The market can remain irrational longer than you can remain solvent.”
Now, I believe in a generally efficient market, but not the one you read about in college. The textbook theory of efficient markets describes a world were security prices constantly move toward “real” value. Where information is instantly decimated, asset, and priced into security valuation.
In real life, the “correct” assessment of information isn’t so black and white. Especially since in real life, economic data is often pointing in multiple directions at the same time. Market participants must then weight various bits of data to make a valuation determination. Some will put more weight on certain pieces of data, while others will overweight other items.
This is starkly evident in the U.S. Treasury market right now. I’ve argued that inflation is of little concern here, despite some improvement in the economy. I point to data like today’s release of Personal Income and Spending. It shows that consumers have more income to spend for the first time in 7 months. But they aren’t actually spending that income: Expenditures declined by 0.1%. I’ve said it before and I’ll say it again, there is no consumer inflation without consumers spending more money in nominal terms. Deflation is the bigger worry when consumer spending is declining.
Others take the other side, arguing that massive government deficits and the ever-running Fed printing presses will cause inflation. The dollar and foreign willingness to own U.S. Treasuries also plays into the bearish Treasury view.
The difference of opinion is especially wide now. The inflation camp suggests 10-year Treasurys rise to 6-7% or even higher. The deflation crowd currently sees a 10-year Treasury yield which is currently above typical real yield. The median real 10-year yield (just taking 10yrs minus CPI) is about 2.9% since 1989. If I assume inflation will print at or near zero in the coming months, then Treasuries seem like a deal at 3.70%. Obviously if you foresee inflation accelerating to anything above average, even something as benign as 4%, Treasury yields are far too low.
No near-term event is really going to resolve the debate either way. The economy has improved substantially since last fall, when I was writing most about deflation. Despite this, I still see a consumer preoccupied with balance sheet repair than buying new dishwashers. The inflation crowd is the same way. When the dollar was stronger earlier in the year, I didn’t see the inflation crowd backing off, and why should they? Their basic thesis was still in tact.
The perception of the debate is colored day by day based on where the market is going. Friday the Treasury market was up substantially and I got a few e-mails congratulating me on my recent buy. I responded (and I blogged) that I thought it was just a month-end extension, not a validation of my view. Lo and behold, the rates market gets crushed today.
In fact, I argue that an argument always sounds smarter when its backed up by recent market moves. I can’t tell you how often investment managers and traders come on CNBC and make an “argument” for a certain position that doesn’t contain any argument at all. For example, if one went on CNBC and said “I think the long bond is going to 8% because inflation will spike, the Asians will dump Treasuries, and the deficit will get out of control.” That’s not really an argument is it? Its just a statement of cause and effect. We know Treasuries will get crushed if those things happen. The question is why might those things happen. Right? That argument is like a detective pronouncing a case closed after determining that the victim was shot. Who shot the victim is the real question.
Anyway, if you make the Treasury bear case on a day when Treasuries are getting crushed, the human mind instinctively find your argument more compelling. This guy says the Treasury market is going to get crushed, and look at it! Its already happening! If you watch, you’ll notice that on any given day, CNBC tends to have more interviews with people who agree with that day’s market action than not. Can’t be a coincidence. It makes the casual observer feel like CNBC has on smart people!
What makes this all tough for the serious analyst is that you have to balance holding firm to your viewpoint while admitting you could be wrong. Its another way of saying that the toughest thing in investing is a sell discipline. I’m long Treasuries now (only avoided a real shellacking based on some good technical analysis). I believe in my deflation thesis, but I know I could be wrong. The inflation camp isn’t stupid. There is a valid argument for much higher interest rates. The smart trader puts his ego aside and admits when he’s wrong.
Many have e-mailed me asking for signposts that I’m wrong. I know what my signposts are, but I’d rather put it back on the readers. E-mail me (accruedint AT gmail.com) with the best arguments you have (could be your own, another blogger, a research report, etc.) for a significant Treasury sell-off. I read a lot of arguments myself, of course, but I won’t pretend that I read everything. Send me the best stuff you have. Over the course of this week, I’ll respond point by point to some of the best pieces I get. While I’m making my points, I’ll also try to show the indicators I’m watching that would tell me that I’m wrong and the opposing writer is right. We’ll call it Deflation vs. Inflation week! Its a smackdown!
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