Forget About Inflation in 2010

When I told Fools not to worry about inflation in 2009, people thought I had lost it. The Fed was printing, the Treasury was minting, and yours truly talked of deflation. Well, 2009 is over, and my thesis turned out to be right -- and I think 2010 will see a similarly benign outcome.

That said, I have no guarantees for 2011 or 2012, but my gut feeling tells me that the numbers below will look very different then. The following chart shows the year-over-year change in the Consumer Price Index from month to month for the last 10 years.

The numbers don’t lie

CPI

JAN

FEB

MAR

APR

MAY

JUN

JUL

AUG

SEP

OCT

NOV

DEC

ANN

2010

2.6%

2.1%

???

???

???

???

???

???

???

???

???

???

???

2009

0.0%

0.2%

-0.4%

-0.7%

-1.3%

-1.4%

-2.1%

-1.5%

-1.3%

-0.2%

1.8%

2.7%

-0.4%

2008

4.3%

4.0%

4.0%

3.9%

4.2%

5.0%

5.6%

5.4%

4.9%

3.7%

1.1%

0.1%

3.8%

2007

2.1%

2.4%

2.8%

2.6%

2.7%

2.7%

2.4%

2.0%

2.8%

3.5%

4.3%

4.1%

2.8%

2006

4.0%

3.6%

3.4%

3.5%

4.2%

4.3%

4.1%

3.8%

2.1%

1.3%

2.0%

2.5%

3.2%

2005

3.0%

3.0%

3.1%

3.5%

2.8%

2.5%

3.2%

3.6%

4.7%

4.3%

3.5%

3.4%

3.4%

2004

1.9%

1.7%

1.7%

2.3%

3.1%

3.3%

3.0%

2.7%

2.5%

3.2%

3.5%

3.3%

2.7%

2003

2.6%

3.0%

3.0%

2.2%

2.1%

2.1%

2.1%

2.2%

2.3%

2.0%

1.8%

1.9%

2.3%

2002

1.1%

1.1%

1.5%

1.6%

1.2%

1.1%

1.5%

1.8%

1.5%

2.0%

2.2%

2.4%

1.6%

2001

3.7%

3.5%

2.9%

3.3%

3.6%

3.2%

2.7%

2.7%

2.6%

2.1%

1.9%

1.6%

2.8%

2000

2.7%

3.2%

3.8%

3.1%

3.2%

3.7%

3.7%

3.4%

3.5%

3.4%

3.4%

3.4%

3.4%

Source: InflationData.com, using Bureau of Labor Statistics data.

The key to understanding why all this printing has not (yet) prompted inflation rests right in the latest FOMC statement. Emphasis mine:

Information received since the Federal Open Market Committee met in January suggests that economic activity has continued to strengthen and that the labor market is stabilizing. Household spending is expanding at a moderate rate but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software has risen significantly. However, investment in nonresidential structures is declining, housing starts have been flat at a depressed level, and employers remain reluctant to add to payrolls. While bank lending continues to contract, financial market conditions remain supportive of economic growth. Although the pace of economic recovery is likely to be moderate for a time, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability. With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.

The highlighted passages are self-explanatory. If this contraction in bank lending continues, I believe that the monthly year-over-year CPI changes listed in the table above could turn negative again, just like they did in 2009. Since we already know the treatment option chosen by the Federal Reserve and other central banks around the world -- printing more money -- it is easy to see what the central banks’ response will be: more of the same.

This is why many investors hate bonds and love gold. Over the long haul, I agree that the fundamental picture of the U.S. Treasury market is not good, and that the case for gold is super-bullish. But as long as the euro is disintegrating slowly and surely, and bank lending is contracting, for the time being we can have a rallying U.S. Treasury market, a surging dollar, and gold that's holding steady in dollars and rising in Euros.

Junk may be flying too high
Few investors know that junk bonds trade in tandem with riskier stocks. You can see that when comparing the trading history of SPDR Barclays Capital High Yield Bond ETF (NYSE: JNK  ) and the PowerShares Nasdaq 100 Index Trust (Nasdaq: QQQQ  ) over the past two years. The correlation's not exactly zig for zag, but it is amazingly close. This is because both ETFs represent risk repackaged. In the case of the SPDR ETF, it’s transformed into debt, and in the case of the Nasdaq 100 risk, it takes the guise of equity.

It's surprising to realize that the performance of Apple (Nasdaq: AAPL  ) , Google (Nasdaq: GOOG  ) , Microsoft (Nasdaq: MSFT  ) and Cisco (Nasdaq: CSCO  ) -- a few of the largest components of the Nasdaq 100 index-- so closely correlates to the high-yield market, but there is an easy explanation. 

The failure of many credit markets made the economy so extremely volatile that all risky assets received large markdowns in price. The subsequent rebound in the U.S. economy in 2009 resulted in large markups in the prices of those risky assets. Over the long haul, the fundamental performance of the stocks above will determine their stock market performance, which will probably deviate substantially from that of the high-yield market.

Still  the least risky, for now
The economy is crucial to the performance of the bond market. In cases of economic uncertainly and low inflation, Treasury bonds are the obvious choice. I believe they are the least risky assets in bond land, though I realize that many disagree with that statement. The most liquid ETF following long-term Treasury bonds is the iShares Barclays 20+Year Treasury Bond Shares (NYSE: TLT  ) .

It’s too early to say for certain whether we will see a deflationary wave in 2010, but I would not be at all surprised if we see a surge in Treasury prices and a relative decline of junk bond prices. In short, don't declare the Treasury market dead. Yet.

More on market issues:

Fool contributor Ivan Martchev does not own shares in any of the companies in this story. Try any of our Foolish newsletters today, free for 30 days. The Fool has a disclosure policy.


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