Goldilocks Doesn't Live Here Anymore

Distrusting Bonds

There are plenty of investors who argue that the recent rally in the 10-year Treasury note, sending yields below 4%, indicates that inflation is contained. But while inflation is a big concern of fixed-income investors, a quick check of history shows they aren't very good at guessing where it's going. For example:

The yield dropped from 4.04% to 3.13% from the end of April to June 2003. During the rally, monthly CPI numbers showed prices dropping. After the 10-year's yield bottomed, inflation accelerated. Trailing 12-month CPI had risen by 3.3% in June 2004, the highest in three years.

The yield dropped from 5.68% to 4.16% from May to October 1998, during the Russian debt crisis. Trailing 12-month CPI, which had risen 1.5% through October 1998, was up 2.6% over the subsequent 12 months.

The yield jumped from 5.83% to 7.84% in 1994. Inflation barely budged, increasing from 2.6% in 1994 to 2.8% in 1995.

It's also said that the historically low yield on the 10-year signals that the economy is slowing, or even entering a recession.

But Legg Mason senior market analyst Barry Webb compared the 10-year yield to growth in gross domestic product going back to 1976. He didn't find much evidence to back up the conventional wisdom.

"You can make the argument that exactly the opposite is true," said Webb, who isn't part of Bill Miller's mutual fund management team.

High yields in the late 1970s foreshadowed weak growth and a recession in the early 1980s. Then, falling yields in the 1980s helped usher in two of the longest postwar expansions from 1982 to 1990 and from 1991 to 2001.

Denouement

Interestingly, almost whomever you believe about inflation, the picture isn't bright for stocks. If inflation remains low when companies can't pass on higher materials costs, profits will be increasingly squeezed. Low inflation from a weak economy isn't good for stocks either.

And if inflation starts taking off, expect the Fed to get more aggressive about raising short-term rates while the bond market takes a nose dive. That would drive up long-term rates, removing one of the greatest sources of strength in today's economy.

Greenspan is expected to retire as Fed chairman on Jan. 31, 2006, when his separate 14-year term as a Fed board member ends. His replacement can expect a short honeymoon.