Bond funds are guaranteed losers

By MarketWatch
10 Aug 2012

"Currently a level of unemployment of 7% or more seems to be required to keep inflation from accelerating, a level quite unacceptable as a permanent situation."

Before Bill Gross proclaimed that "the cult of inflation may only have just begun," I discussed here a few months ago that we were likely already “ Passing from deflation to inflation .”

I was not alone of course. A quick search shows that many people have been talking about inflation for a few years now. Most, however, have just been making knee-jerk reactions to their not-terribly-well-informed observations of the Fed.

What good mathematicians know however, is that the Fed hasn't quite printed us into inflation just yet. We are at an important juncture, however. In the next year, the world will have to decide between a deeper depression or moving back to growing the global economy.

While it is possible that we choose a deeper depression in some misguided effort to follow some silly economic theory, the more likely scenario is an effort by governments to preserve the standard of living of those with a standard of living worth preserving and improving the lot of billions of others who might otherwise be prone to rebel.

Under the scenario where governments attempt to stimulate growth, inflation will follow. There are several reasons we will see inflation, including monetary, fiscal and scarcity drivers.

We have already seen most (ex-Germany) of the central banks around the world implicitly and explicitly support growth. Local and national governments, if for no other reason than to preserve their positions, are also looking for growth initiatives. And while there is a short-term energy surplus, we know that will not last long. Lack of investment, drought and depletion are increasing scarcity, and thus, prices for water, metals and food will rise, and will soon for energy.

As growth rebounds over the next few years and aging populations around the world retire, the unemployment cushion against inflation will disappear. When that happens, interest rates will rise and many bond funds will get crushed.

People who are holding onto bond funds now, while they might feel safe, and indeed could be safe for another year or so, might not be so safe if something is new some morning. Indeed, people holding bond funds in many cases are already losing purchasing power due to historically low interest rates.

Right now there is a sweet spot in some not-quite-junk corporate debt, however, that will not last much longer. Once more government interest rates rise and bigger investors jump to move, bond fund holders will be left holding the hot potato just like all the other times we have seen sharp interest rate rises.

Cash is not a good long-term holding either, though I prefer it due to the slower-moving degradation while it is parked. The trick, of course, with cash is to unpark it when opportunities arise.

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