Quote from Daal:
One could argue that this global sovereign debt crisis will put an end to the decline in global real interest rates that started in the 1980's. So even IF there are disinflationary/deflationary pressures in a certain country, that does not necessarily mean that the gov debt is a good buy because that is being offset by the higher premiums that the market is demanding.
That seems to be the case in the US, at least so far, inflation measures have been disinflating yet the yield on long-term debt has been increasing. If the stock market takes a dive that could change but thats a lot of IFs, specially considering that there are superior ways to play that same theme(I dont think gold is one of them given that decline in real rates in the 80's and 90's didnt do much for the price of gold)
We do have a couple of past examples of ballooning deficits and debt loads, combined with non-existent inflation - USA in the 1930s, and Japan from 1990 to present. In both cases there were secular bull markets in bonds that drove 10 year bond yields to the 2 lowest readings in recorded human history - 1.5% and 0.5% respectively. Admittedly the 1930s was on the gold standard until 1933, but Japan wasn't. So if the bear case on bonds is that there are ballooning deficits and debt burdens - well, that has been proven to be irrelevant before compared to the inflation outlook.
Which means the bear case rests on inflation outlook alone. What is interesting is that most of the bears, e.g. Marc Faber, just assume inflation, rather than explaining why it will happen. Their reason is "money printing" by the Fed. But that isn't the cause of inflation. The cause of inflation is credit creation in the banking sector. If credit creation remains weak - and there are a host of financial, economic, social, and regulatory reasons to think that banks will be reluctant to return to the aggressive lending of the past - then the inflation case is a bust.
IMO the bullish case is robust, based on historical precedent and apparent fundamentals. With 10 year yields now close to 4%, if the bulls are right then you are looking at real yields of 4% for the next decade. Clearly if inflation goes to zero (or negative) then bond prices will soar and nominal yields will fall to 2% or lower, as they did in Japan.
As for the downside - that is also appealing. If the bull case is wrong, and inflation returns, we will find out in the next 12-18 months in the data. Technically, bonds have just retested their summer 2009 lows - but despite the huge stock and risk rally since then, they haven't decisively broken below support, which is what you would expect if an inflation/robust recovery story were happening. So there is a bit of a message from the market there, bonds are acting quite resilient despite the apparent flight into risky assets and away from safety. Finally, valuations are actually not too bad. Let's say the recovery is solid, what inflation rate would we expect, maybe 2%, 2.5%? Treasury 10 years were yielding 4% just a short while ago. 1.5-2% real yield is not great but it's not terrible either. Are we really to expect that inflation will be higher than in the 2004-2006 period? If you look at 30 year yields, right now they are 4.75% - compared to 4.5% in 2005-2006. In other words, bonds are actually reasonably priced today even if the economy is healthy. Even the wildest bull has to admit that the economy in 2010 has more apparent problems than the market thought it had in 2005-06.
As long as you do not believe the "Zimbabwe Fed" interpretation (which no one other than Faber and the tinfoil hat brigade take seriously), then bonds have low downside, an inherent low-risk/long gamma positive carry, and a significant upside capital gain potential in the event of a secular decline in bank lending and inflation over the next 5-10 years. Basically you are getting paid 2% real returns per annum to hold a free option on long-term mediocre growth, and as long as Ben doesn't bring out the helicopters, the chances of major loss are very small indeed. In the worst case, if 10 year yields rise to 4.5-5% and for some reason Bernanke thinks that a robust recovery is the perfect signal to start a hyperinflationary spiral, you can always take your moderate single digit % loss and exit the trade.
