Bill Tedford is a market-beating bond manager at Stephens Inc. A recent Wall Street Journal article profiled his market outlook for higher inflation. Although I was not familiar with Mr. Tedford, the article had an interesting comment on his thoughts about the linkage between the monetary base and subsequent inflation.
The key data point in Mr. Tedford’s model: the monetary base, basically money circulating through the public or reserves banks on deposit with the Federal Reserve. Over long sweeps of time, he says, inflation closely tracks increases in the monetary base that exceed economic growth.
For instance, he notes, in the 40 years to 2007 the U.S. monetary base grew at 7.08% a year. Gross domestic product, meanwhile, grew at 3.04%. The resulting surplus monetary-base growth of 4.04% closely matches CPI and the personal-consumption-expenditures price index, another measure of overall inflation.
I always love models that are based on actual data, so that’s a pretty interesting relationship. Of course, recently the monetary base has exploded. According to the article, the monetary base has grown 11% in the past 15 months, during which GDP has actually declined 2%. The article also notes some caveats to his thesis, but it’s intriguing nonetheless.
One troubling aspect of recent media coverage is this: quite a few notable bond managers including Bill Gross, Dan Fuss, and now Mr. Tedford expect bond yields to go higher (and thus prices to decline) at the same time that the public is piling into bond funds. It’s too early to tell how things will really work out, but it certainly something to keep a close watch on.
It may be true that inflation is coming. However, I’m amazed at the numbers of people who predict that beneficiaries of inflation, such as gold, will continue the ascent, seemingly forever. What most people forget is that the financial markets ANTICIPATE events. The big climb in gold is forcasting future inflation. But for how far into the future? An astute investor wouldn’t extrapolate gold’s rate of increase too far into the future but that’s what the crowd, which is usually wrong, is doing. Notice all the comercials telling individuals to buy gold … and notice all the comercials telling individuals how much cash they can get for their gold. When the Hunt Brothers thought they’d cornered the silver market, silver bracelets, rings, candle holders, silverware, came out of the woodwork and onto the market and silver colapsed. Might the same thing happen to the gold market?
It is certainly true that markets trade on expectations, not reality. It’s never clear in advance how far a trend may advance, but it seems trends rarely stop where the public expects them to-often going far longer than the public expects or falling far short of expectations!