Bond Prices and Inflation

Saturday, wait
Sunday always comes too late
But Friday never hesitates
--The Cure

We've noted it before but let's say it again. Generally, bonds and inflation are positively, not negatively, correlated. Appropriately defined, inflation is an increase in supply of money. In the current system, money is primarily credit money. Credit money is created by fiat rather by saving, and generates dollars that are created linked to liabilities.

Credit money has been expanding in a big way for the last 30 years. This is because the interest rates associated with borrowing this credit money have been suppressed. Yields on 10 yr Treasuries have fallen from north of 15% in the early 1980s to below 2% earlier this year. As the interest rate on a bond falls, its price goes higher.

Get that? Bond prices have been rising for the past 30 yrs because of inflation.

The kicker is that cheap interest rates make it attractive to speculate with borrowed money. What do you suppose has been the go to asset class for carry traders? That's right, B-O-N-D-S.

Question: How much money would you borrow at 0% if you could invest in in Treasuries yielding 2%.

Answer: (provided by bankers and other carry traders worldwide) "As much as you can."

Thus, inflation provides a secondary kicker to bond prices due to the carry trade.

What stops this virtuous cycle? Risk aversion. Less willingness to lend or borrow. Higher borrowing rates from creditors.

When this occurs, bonds get sold, the value of existing debt goes down, and less new credit money is created. This is deflation. Credit money supply contracts.

In a monetary system that primarily creates credit money, then bond prices go up when more credit money is created (inflation). Interest rates go down during inflation, not up.

In deflation, bond prices go down when credit money is destroyed (deflation). Interest rates go up.

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