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Bonds: How Will They Do in a Deflation?
Investors got burned twice over the past few years: first it was the drop in the stock market, then in commodities in 2008. So now they are piling into bonds -- municipal bonds, in particular. Why is that a bad idea with a deflationary depression in the offing? Here's what Bob Prechter said about how bonds will act in a deflation more than five years ago, and it's all beginning to play out now.
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Credit will contract [in a deflation]?
Bob Prechter: Yes, from long-term bonds al the way down to the broader measures of the money supply.
The credit implosion you see leads you to contradict the most deeply held convictions on Wall Street, like the conventional belief that bonds rise when the economy slows. You have most of them falling in a weak economy.
Bob Prechter: It's plainly not good for bond values if the issuers of bonds, i.e., the borrowers, suffer financially to the point of not being able to pay interest or principal, is it? In fact, billions of dollars worth of bond defaults in recent years clearly reveal the problem. What economists should say is that (1) in an environment of general growth and inflation, (2) when only a recession occurs, and (3) when the recession brings a reduction in inflation, then bonds typically rise in price as interest rates fall. Unfortunately, to most economists, the post-World War II period is the only relevant history, so bond investors don't place their view in the larger context of economic possibilities.
At what point might the economy deteriorate so substantially that its condition and trend are no longer bullish for bonds, but bearish?
Bob Prechter: When it reaches depression, and a depression is exactly what is on the agenda if the stock market falls to the extent that the Wave Principle suggests. The only way for a bond investor to survive a depression is to hold bonds issued by a strong borrower. Weak borrowers, such as most corporations and municipalities, will default. As investors come to the realization that default is a risk, rates on weak debt will rise as its prices fall.
What happens to the dollar?
Bob Prechter: During the deflation, the dollar's domestic purchasing value should rise as debt instruments denominated in dollars are defaulted upon. As dollars disappear, the value of the remaining dollars will rise….