THE 30 YEAR BOND'S RETURN MAY PORTEND INFLATION

August 11, 2005 – A major ongoing debate has consumed the investment community regarding whether inflation or deflation is in our future. This is understandable because the impact of its resolution, upon both our investments and our personal lives, hangs in the balance. I believe that the recent official pronouncement that 30-year Treasury Bonds will again be offered, likely announces our government’s opinion of our fate.
The four-year hiatus of the U.S. government’s issuance of 30 year Treasury Bonds is coming to an end. Prior to its slated permanent termination in 2001, it was a mainstay in the Treasury Department’s debt issuance arsenal. For decades they were actively sought worldwide by investors who desired the safety and liquidity that they offered. This global demand gave our government a willing contingent from which they could fund their capital needs, thereby allowing our officials to pay our bills. They were auctioned whenever budget deficits occurred, and offset America’s regular tax revenue shortfalls.
When the 30-year bond was eliminated the Fed was already in the midst of actively orchestrating a major reduction in interest rates. Further, they were simultaneously flooded the banking system with liquidity. They were performing these acts in an effort to reverse the recession that was consuming our nation.
At that time, it seemed odd to me that they would retire the 30-year bond primarily for the stated reason that demand for it had dwindled. After all, it had served for decades to help the government acquire the capital needed to remain solvent.
To my mind, the recent announcement that this vital monetary instrument would again be issued may have far reaching implications. And, if I am correct, the reasoning behind its reinstatement exhibits good business judgment on the part of our government, and insight into what they believe is our future.
In 2001, and with short-term interest rates plummeting, the U.S. Treasury ceased issuing bonds of 30 years duration. I believe that this was a monumental error. After all, with rates moving towards generational lows the U.S. had the ability to borrow needed funds while paying little in the way of interest. Additionally, they would have the use of the proceeds for the following three decades.
With their recent announcement I believe that our government finally acknowledged their judgment error in terminating the Treasury Bond offerings. Further, I feel that their reason for reintroducing them at the present time is crucial. It is due to their belief that interest rates are destined to move to loftier levels, and denotes their view that inflation is likely. This, despite the rhetoric that inflation will remain under control.
Many in the deflation camp have written off the Federal Reserve’s past ten federal funds rate hikes as being a mistake in judgment. These individuals state that the declining long bond interest rates, while short rates are simultaneously rising, indicate that deflationary winds are being fanned. After all, history is replete with periods when long-term interest rates declined whenever our economy approached or experienced a recession. Further, they point to the flattening and possible inversion of the yield curve, as testimony to the inevitability of this event. I now believe that they are wrong.
It is my belief that like the Fed, our government now believes that the economy has sufficiently strengthened to prevent a return to recession. Further, by reissuing the long bond they can attract a substantial amount of funds to our government coffers.
I have read that the government expects to hold two annual $20 billion to $30 billion bond auctions. I believe their hope is that they will be successful and attract far more than this modest sum. Further, if inflation is in the cards it will erode the ultimate value of the dollars that the government must repay upon the maturity of these bonds. In effect, when the bondholders redeem their bonds the proceeds will purchase far less than the money they used to buy them.
Given the fact that the dollar has lost well over 85% of its purchasing power during the past seven decades, it is reasonable to assume that purchasers of the new Treasury Bonds will suffer a similar fate as have earlier bondholders. In effect, when the investors redeem their bonds the proceeds will purchase far less than the money would have when they bought them. This will accrue to the benefit of our government and nation, as this debt will be repaid in cheaper dollars.
If my analysis of our government’s reasons for issuing the long bond is correct, what is its significance? First, it indicates that Fed sponsored rising short-term interest rates will continue for the foreseeable future. This will further pressure lower all Treasury paper as well as other domestic debt instruments, and simultaneously force higher their interest rates. Next, the threat that the advancing rates will spark housing market and economic declines will increase. Further, inflation will be our leaders dominant fear.
This does not mean that inflation is a certainty and that deflation will not occur! It only indicates the fashion in which an investor should expect our government and Federal Reserve to act, and how they will attempt to influence the markets. The government may very well be wrong, but I believe that they are now directing their actions to stave off inflation. This will be the dominant direction of our monetary and fiscal policy’s influence for the foreseeable future.
In any event, the action of the Federal Reserve will be the easiest and likely the most reliable indicator to watch. They will give investors the first sign of what our government is thinking and fighting. If the Fed continues its measured Fed Funds increases, it will signal that inflation remains their greatest concern and that its assertive return is likely. However, if they begin to reverse their rate hikes and instead lower their Fed Funds targets, beware! It will be the first indication that they are losing control and that the likelihood of deflation and recession is rising.
This is only a theory at present. However, if I am correct about the government’s rising belief that inflation is our primary threat, the ultimate investments will be those that parallel the best performing items during the inflationary period of the 1970's. They were gold, silver, gold and silver stocks and tangibles such as commodities and rare coins.
Again, we have a major advantage by being able to observe the Federal Reserve’s actions. The direction in which they move their Federal Funds rate target will be the leading indicator. It will tell us what they are thinking, and it will announce the rise of inflation if it continues higher, or the likely spread of deflation if they reverse course.

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CAVEAT

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FINANCIAL INSIGHTS is written and published by Dr. Richard Appel and is made available for informational purposes only. Dr. Appel pledges to disclose if he directly or indirectly has a position in any of the securities mentioned. He will make every effort to obtain information from sources believed to be reliable, but its accuracy and completeness cannot be guaranteed. Dr. Appel encourages your letters and emails, but cannot respond personally. Be assured that all letters will be read and considered for response in future letters. It is in your best interest to contact any company in which you consider investing, regarding their financial statements and corporate information. Further, you should thoroughly research and consult with a professional investment advisor before making any equity investments. Use of any information contained herein is at the risk of the reader without responsibility on our part. Past performance does not guarantee future results. Dr. Appel does not purport to offer personalized investment advice and is not a registered investment advisor. The information herein may contain forward-looking information within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. In accordance with the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, the statements contained herein that look forward in time, which include everything other than historical information, involve risks and uncertainties that may affect the company's actual results of operations. © 2005 by Dr. Richard S. Appel. All rights are reserved. Parts of the above may be reproduced in context, for inclusion in other publications if the publisher's name and address are also included for credit.