Bonds' Reprieve Will Not Last Long

03/30/2011 1:06 pm EST

Focus: BONDS

Mary Anne & Pamela Aden

Co-Editors, The Aden Forecast

Interest rates will head higher again soon enough, as deficit spending and inflation expectations take their toll, write Pamela and Mary Anne Aden of the Aden Forecast.

Even though interest rates declined this month, that’s not unusual following their steep rise since last fall, and we don’t expect this will last long.

For now, the 30-year Treasury bond yield, which is a free-market, long-term interest rate, is holding near its megatrend at 4.50%. This 80-month moving average has identified the interest-rate megatrend since the 1930s.

Chart1

As you can see, the megatrend has been down since the early 1980s, but this now appears to be changing. If this trend is turning up—as we suspect—it would mean a total change in the overall economic environment. And it’ll last for decades, because once these trends change they last a very long time.

Most important, it would strongly reinforce the notion that big inflation is indeed coming. In fact, aside from the developments we’ve already seen, this would be the final confirmation that it’s happening.

On top of the mushrooming debt, deficits, spending, and money creation that’s currently in place, there are two important factors that nearly guarantee this trend.

Baby Boomers and Bust
First, the bulging baby boom population is now entering its retirement years. Thousands of people will reach age 65 every day for the next 19 years. That’s going to mean way more Medicare and Social Security spending, which is going to balloon the deficits even more.

Already, the deficit will be more than $1 trillion next year for the fourth consecutive year. The baby boomers alone tell us that the deficit is going to keep growing, despite what anyone says.

Second, interest payments on the debt are expected to grow to four times what they are now over the next decade. If interest rates rise as we anticipate, this growth could be even greater.

All of these factors absolutely coincide with big inflation in the upcoming years. In fact, it’s already starting to happen.

Producer prices in the US recently had their biggest gain in 2 1/2 years. And in the last four months, producer prices have risen at a 9% annualized rate. We’re fairly certain there’s a lot more coming.

Inflation and interest rates are currently rising in most countries. The US is now following the global trend.

Some, however, agree with Federal Reserve Chairman Ben Bernanke that inflation won’t become a big problem. If anything, it’ll just be temporary, they argue. The quantitative easing (QE) program is working and the Fed is determined to keep interest rates down as it continues on its bond buying binge, which is helping to maintain stability.

Next: Dissensio in the Ranks

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Dissension in the Ranks
But it’s not a coincidence that two well respected central-bank officials resigned last month, one at the Fed as well as the head of the German central bank.

In both cases, they opposed the monetary path the Fed and the European Central Bank have chosen—that is, creating money to purchase government bonds, which is beyond the range of normal central-bank policy.

Chart2

In other words, it’s downright risky—yet it’s been going on since the financial panic of 2008.

Once again, the world is in uncharted waters. Very simply, it’s a dangerous situation, and no one really knows when, where, or how this will all end up.

For now, the Middle East is brewing, in large part because of soaring food prices, which is a result of what we’ve been discussing. Nevertheless, in times of crisis, US bonds are often still seen as a safe haven, and that’s one reason why interest rates have been declining—there’s been more demand.

This could continue, and it could drive rates even lower in the weeks ahead. The ten-year yield’s leading indicator was overextended, and a downward correction would be normal at this time.

But even if the 30-year yield declines to 4.30%, the major interest-rate trend would still be up. And as long as it stays above 4.50%, the megatrend will be turning up, with all that it represents.

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