John Hempton writes:
We live in a strange world – the 10 year US Treasury is trading with a 2.63 percent yield. The market is presuming that there will not be much inflation in those ten years. However if there is deflation (as per Japan) then the 10 year will wind up being a very good investment (see my blog post on Japanese bond yields from the perspective of a Japanese household).
At the same time gold is appreciating very sharply – from $950 per oz to $1250 in the past year – and from $800 two years ago or $450 five years ago. On the face of it the gold price is predicting inflation.
Try as I may – I can’t see any reason why both those prices are correct. I have long held the view that prices are mostly sort-of-rational … [s]o either there is a theoretical way in which both these prices can be correct or even my weak version of the efficient market hypothesis is spectacularly wrong.
and then asks
My first question thus is can anyone tell me why these prices could possibly be consistent? Is there a rational reason why the bond market is pricing low inflation and the gold market seemingly pricing high inflation? Does anybody have the ingenious world view in which both these prices are correct?
Since Blogger rejected my comment over at John’s site as being too long, I may as well reproduce it here. I don’t know about “correct” and I’m no finance guy, so my first point is that I have no freakin’ clue. Nevertheless, here are five, somewhat contradictory ideas, three of which might fit in a weak EMH world …
Idea #1) Yes, yes, your whole post was predicated on some weak version of the EMH. However … Treasuries, despite what the arch-conservatives are saying, are unlikely to be in a bubble (see idea #4 below). It might (and only might!) even be impossible for them to be in a bubble. On the other hand, gold can experience a bubble (to the extent that you concede that bubbles can exist at all). Just because it can doesn’t mean that it currently is in one, but if it is and treasuries are not, that would partially resolve your dilemma.
Idea #2) Gold, as a commodity, is a affected by global phenomena, whereas US treasuries, while obviously still influenced by global pressures, are more sensitive to the US economy than is gold. This statement will become more true over time as the US economy shrinks as a share of global GDP. Therefore, perhaps you should deduce that markets are predicting low inflation or deflation for America, but quite high inflation for the world as a whole.
Idea #3) Gold, as a commodity, partially co-moves with other commodities, many of which are seeing price increases because of real, observable events in their markets (Chinese construction, Russian drought, etc). Perhaps it is being dragged up by those (this augments idea #2).
Idea #4) In the broad market for USD-denominated investment-grade bonds, there has, I believe, been a net contraction in supply despite the surge in US government borrowing. This is the private-sector balance-sheet correction. One might argue, from something of a monetarist point of view, that (disin|de)flation is occurring in the US precisely because the US government is not expanding its borrowing fast enough to replace the private-sector contraction. I mentioned this briefly the other day.
Idea #5) Another non-EMH idea, I’m afraid: Both the USD and gold enjoy safe-haven status. An increase in generalised fear (Knightian uncertainty, unknown unknowns, etc) will shift out the demand for both at all price levels. To the extent that such a dynamic exists, I suspect that it ebbs away only slowly and, while elevated, is susceptible to rapid increases in response to events that would, in normal times, not affect people so much.
Update 11 Oct 2010:
James Hamilton on essentially the same topic.