What is the More Rational Prediction for the Future-Inflation or Deflation

This is a continuation of my introductory comments contained in my post from last Saturday, where I discuss inflation risk and bonds. Near the End of A Long Term Bull Market in Bonds Staring in the Early 1980s?

The preceding chart shows the non-seasonally adjusted consumer price index since around 1950. St. Louis Fed: Series: CPIAUCNS, Consumer Price Index for All Urban Consumers: All Items I was born in 1951 and it would take $8.39 in 2010 to have the same buying power as $1 in 1951. CPI Inflation Calculator Given this history, deflation is not the reasonable prediction for the future, notwithstanding the protestations of perma stock market bears who advise investors to buy 10 year treasury bonds yielding less than 3%. A more reasonable approach would be to postulate a continuation of this long-standing inflation trend and then attempt to manage my bond positions with inflation risk in mind.

Possibly, I am hypersensitive to the possible emergence of problematic inflation. The inflation problem in the 1970s started slowly at first in the mid-1960s and then gathered momentum into the 1970s. The policy responses were not too encouraging. The Republican President Richard Nixon imposed wage and price controls which probably aggravated the problem. Nixon, Price Controls Gerald Ford had his idiotic "Wip Inflation Now" buttons: WIN buttons Jimmy Carter was just hapless. It took almost fifteen years for Paul Volcker and the Fed to impose the solution, which proved to be a painful one, by drastically increasing the federal funds rate between 1979 to 1983. A 30 year government bond could have been purchased in 1982 with over a 14% yield. www.federalreserve.gov That is the jumping off point for a long term secular bull market in bonds. The 30 year treasury is yielding close to 4% now Java Chart - WSJ.com U.S. Government Bonds A long term bull market in bonds does not start with a 4% yield, anymore than a long term secular bull market in stocks is likely to continue from Nasdaq 5000 after an 18 year up move (starting at around 180 in August 1982: NASDAQ Composite Index Chart).

I previously referenced a speech by the Philadelphia Federal Reserve President who sees parallels between the 1970s and the current situation. Philadelphia Fed.

I previously outlined in a post the measures that I am taking to manage interest rate risk: Managing Interest Rate Risk While I am doing my best to cushion the impact on current income generation due to the Fed's 2 year Jihad against savers, I am cognizant of the risks in bond funds and long term bonds. Consequently I am taking some measures to deal with interest rate risk now.

In addition to the several steps discussed in that post, I am also periodically paring long term corporate bond positions, primarily those postions where my purchase price results in a current yield of less than 8% and the price paid was near par value. I am also trading some of my bond fund positions for profits in measured amounts. For example, I sold last week $1000 worth of shares in two Vanguard Intermediate bond funds, one investing in tax exempt securities and the other in investment grade intermediate term corporate bonds. Those funds will be used to buy individual stocks with yields higher than those bond funds and a history of raising their dividends.

I also have predetermined exit plans for buying certain of the bond funds that were purchased in the past year. One trigger is an increase in the yield of the 10 year treasury bond to over 4%, while another is an increase in the 3 month LIBOR rate to over 1%. The later trigger is designed for a bond fund that uses leverage with the borrowed funds tied to a spread over the LIBOR rate.

Another strategy, being utilized in a taxable account, is to buy the Canadian 1 to 5 year government and corporate bond ETFs that use a short term ladder approach. This mitigates interest rate risk some given the short maturities and the use of the ladder. In short, it is impossible for me to act based on the belief that 3% yields on 10 year U.S. treasuries is a good rate, and one likely to decline in the years to come. Everyone needs to arrive at their own solution. I will predict now that many who bought bond funds within the past year will ultimately lose money in those investments by holding them well into a rising interest rate period.

This is the Fed's weekly data on the 10 year note going back to 1962: www.federalreserve.gov It is important to keep in mind that a 3% 10 year bond will lose a lot of its value when and if new 10 year bonds are priced to yield say 5% or 6%. Unlike the purchaser of a bond fund with intermediate term treasuries, the buyer of that 10 year note can hold until maturity and receive par value. Bond funds do not promise to return an investor's principal back and do not have maturities except for a limited number of term date funds. But the buyer of that 10 year bond at 3%, when faced with a rise in rates to 5%, has a dilemma. Do I sell for a loss and buy a new bond yielding 5% or stay with that 3% bond until maturity? At a minimum, in this type of scenario, the buyer has experienced the risk of lost opportunity.

I think that it is helpful from time to time to display the CPI rates from 1965 to 1982. (source: Consumer Price Index, 1913- | The Federal Reserve Bank of Minneapolis) History may not repeat itself-exactly, but the past is often prologue as individuals and governments repeat over and over again the same mistakes from the past. Unknown to almost all investors at the time, 1965 was the start of an extremely treacherous period for both bond and stock investors, a period dominated by stagflation (anemic growth coupled with problematic inflation). At the start of the following table, both bonds and stocks were about to enter a long term secular bear market lasting 17 years. While I am not predicting a return to stagflation, it is a rationale forecast for the future that can not be dismissed now out of hand.

There are a number of soothsayers who are predicting an onset of deflation. Paul Krugman, the liberal economist, wants the U.S. government to increase its deficit spending, currently running over a trillion dollars per year, to avoid the onset of the next Great Depression. Krugman-World on the Cusp of a New Depression He repeated his concerns in his NYT column today, arguing that the Federal Reserve needs to do more than just keeping interest rates near zero. Otherwise, Krugman warns that the U.S. will "be seeing deflation by sometime next year". More is needed from the Federal Reserve according to Krugman in order to "head off an American version of the Japan syndrome", a long period of stagnant growth coupled with low levels of inflation or deflation. While it is conceivable that Krugman may turn out to right, it is also possible that the Sun will go Supernova later today and we will no longer have to worry about this debate. Krugman's thesis has been in vogue since the onset of the financial crisis, primarily among liberals who want the government to spend trillions more of borrowed money. My initial response to their arguments was given in past from 2008: the Japanese Experience with Deflation

I would give Krugman's dire forecast about a 5% chance of actually happening. A more likely course would be something similar to the late 1960s and 1970s, based on the extent and the duration of the unprecedented fiscal and monetary stimulus.

The number in the right hand column is the annual rate of inflation. The scenario viewed as more likely than the one advanced by Krugman would place the U.S. in 2010 back in 1965. Still, even this scenario is not viewed as the most likely one, just far more probable than Krugman's scenario.

1965	31.5	1.6
1966	32.4	2.9
1967	33.4	3.1
1968	34.8	4.2
1969	36.7	5.5
1970	38.8	5.7
1971	40.5	4.4
1972	41.8	3.2
1973	44.4	6.2
1974	49.3	11.0
1975	53.8	9.1
1976	56.9	5.8
1977	60.6	6.5
1978	65.2	7.6
1979	72.6	11.3
1980	82.4	13.5
1981	90.9	10.3
1982	96.5	6.2

PKK, the trust certificate with a Liberty Media bond, is ex interest today for its semi-annual payment. www.sec.gov The underlying bond is rated in junk territory. FINRA I pared my position in TCs containing Liberty Media bonds last year but I still own 100 shares of PKK.

OSM, the senior bond from SLM that pays interest tied to CPI, is ex interest today for its monthly interest payment. For a detailed explanation on how this distribution is calculated see Item # 1 CPI.

JZH, a trust certificate containing a senior Prudential bond, is also ex interest today. I own shares in both the regular IRA and a taxable account with some shares purchased at less than $10 during the Near Depression period. TRUST CERTIFICATE JZH: PRUDENTIAL SENIOR BOND The last purchase was at $21 in May 2010. I pared JZH some and reinvested the proceeds into what turned out to be timely buys of PFK, another senior bond from Prudential that pays interest tied to the CPI and matures in 2018: Bought 100 PFK at $18.46/ Bought 90 PFK in IRA at $18.94 /Added 50 PFK at $17.83

MLPI, the recently acquired ETN which owns publicly traded master limited partnership units, is also ex dividend today. Large Cap Valuations Bought 100 MLPI at 25.9