Bond Prices and Future Inflation and Deflation

Edwin Rubenstein and Peter Brimlow have just written an interesting article in Marketwatch in which they argue an examination of historic bond prices seem to indicate that inflation is a greater probability than deflation. This conclusion is based on a chart, which shows bond prices for the past 100 years compared to a regression line.

If you look at the chart, you'll see that bond prices are currently above trend. If you believe that prices will eventually revert to the mean, than bond prices have to come down and yields go up (prices and yields move in opposite directions). Rising yields are usually an indication of inflation.

But what if there is another alternative here? What if we are going to enter a period in which rates and the economy part ways. Suppose the economy continues to sputter along but government debt continues to grow at alarming rates. It may require higher rates to finance the deficit. The deficit will crowd out private capital, requiring everyone from consumers to companies to compete harder for the remaining capital, raising rates in these markets.

The rise in rates further depresses the economy. A depressed economy with over $1 billion in idle capacity can hardly raise prices, resulting in low inflation.

The point of all this, is that it's possible to envision a scenario where bond prices fall to historic norms without the usual rise in inflation. The key will be not only bond pricing but unemployment and other macroeconomic indicators.