THE BOND CYCLE AND DEFLATION
I was at an event recently where I was able to see two legends among others – Louise Yamada and Gary Shilling. Louise made the point that while secular phases in the stock market generally last between 12 and 16 years, interest rate cycles tend to be much longer – anywhere from 22 to 37 years; and she has a chart back to 1790 to prove the point! So while all we ever hear is that this secular bull market in bonds is getting long in the tooth, having started in late 1981, it may not yet be over. After all, the deleveraging part of this cycle has really only just begun and if history is any guide, it has a good 5-6 years to go – at a time when practically every measure of underlying inflation is running south of 1%.
Gary not only ran with a terrific chart showing, over time, the gap between aggregate supply and the inflation rate (talk about compelling), but a table showing (and this one goes back to 1749!) how the primary trend during peacetime is one of deflation and in wartime it is inflation (including the Cold War).
Expand your horizons and go back before 1945 and you would see that during the American Revolution, inflation averaged over 12% per year, to then be followed by 28 years of peace that coincided with deflation of nearly 2% annually.
The War of 1812, which really lasted four years, saw prices advance at nearly an 8% average annual rate, while the next three decades of peacetime saw prices deflate by 2.4% per year.
Prices surged at a 15% annual rate during the Civil War and then we went through 51 years in which the price level fell at a 0.7% annual rate. So looking back over the past three centuries, we have had 92 years of war and prices rose at an average annual rate of 6%. Gary goes on to show that when we are not at war, prices typically decline at a 1.2% pace (wars lead to government procurement policies and soaring demand for material that goes into the munitions process).
This is important because while fiscal policy may have a 40% correlation with the direction of bond yields, inflation is twice as important.
Copyright (c) Gluskin Sheff
