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Monday, June 16, 2008

Inflation Kills Bonds

For the longest period since 1980, U.S. inflation has been higher than what investors earn on 10-year notes, a sign that yields have further to rise. Treasuries paid 2.88 percentage points more than the consumer price index the past two decades, according to data compiled by Bloomberg. Investors who buy $1 million of the securities would lose $140,00 over the next year if the relationship returns to normal.

The combination of rising commodity prices, Federal Reserve Chairman Ben S. Bernanke's renewed focus on inflation and his success in reviving capital markets after the collapse of subprime mortgages has turned Treasuries into a quagmire. Investors who bought notes due February 2018 on March 17, just after the Fed helped arrange the bailout of Bear Stearns Cos., have lost 6.2 percent.

Inflation is also eliminating the rewards of owning U.S. stocks. Standard & Poor's 500 Index shares yield 0.2 percentage point more in profits than the interest on 10-year notes, the smallest advantage since 2004. Yields touched the highest since December as oil prices climbed to a record $139.12 a barrel this month, and are up from 3.28 percent on March 17. Unless you subscribe to the notion that the economy will slow and help relieve some of the inflation pressures, bond yields look like they need to move higher and fair value is off in the distance.

This means Interest rates will go up. Mortgage rates will go up. Lending will probably tighten and relief for home sales will be disappearing again.

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