From today's FT ... http://www.ft.com/cms/s/0/bd8252a4-39d7-11de-b82d-00144feabdc0.html Conservative Fed is good reason to be a bull on bonds By Hugh Hendry Published: May 6 2009 03:00 | Last updated: May 6 2009 03:00 What if I told you the price of 10-year US Treasuries fell between September 1929 and January 1932? We endure the greatest deflation of all time, yet government bond prices fall. So, how come bonds are my favourite asset class? Simple, the accumulation of US debt relative to the size of its economy is without precedent. Never has the private sector volunteered to carry such a quantum of risk. This ratio blew out to three times US gross domestic product in 1933 but this was a function of the nominal economy contracting by 46 per cent. Last year, however, even before the horrors of the fourth quarter, the ratio stood at a staggeringly high 3.6 times. In just 60 years, the private sector had increased its debt from 46 per cent of GDP to 175 per cent; just how high could it really go? Almost 300 years have passed since John Law's introduction of paper money and society has deleveraged only twice before. Each time the adjustment has spanned several decades and nominal GDP has contracted. We know now a third turning is at hand. However, our generation has never experienced such a reversal. Real GDP contracted in both 1974 and 1975; it has never repeated the feat and the recession constitutes modern America's most severe downturn. Nevertheless, while real GDP contracted by 1 per cent in 1974, it expanded by 8 per cent in nominal terms. Ominously, today, it is falling. It is understood that nominal GDP represents the stock of money multiplied by its turnover. But I want to suggest that policymakers handicap the data according to whether the private sector is expanding or contracting its leverage. My accounting would add to GDP when deleveraging occurs and subtract when leveraging occurs. Instead, it is as if we made Bernie Madoff responsible for the national accounts. For the private sector's borrowing during the "Noughties" had the perverse effect of super-sizing everything. It's not just Big Macs; GDP became inflated by the ability of debt to expropriate tomorrow's expenditure. The scale of the overstatement becomes apparent as American debtors scramble to repay their loans. The economy once more reverts to type and has to shrink to its rightful size; the deceit is revealed and the nominal economy contracts. Irving Fisher called it a debt deflation, "...each dollar of debt still unpaid becomes a bigger dollar..." And the Fed finds itself in a race to print dollars more quickly than the private sector can destroy them by selling assets for lower prices. This is why its balance sheet will have ballooned by almost $2,500bn after it completes its quantitative easing programme. And yet John Taylor, he of the eponymous monetary policy rule for interest rates when there is slack in the economy, wrote in the FT: "There is no question that this enormous increase ...will lead to higher inflation." I fear the real problem today is the Fed is being too conservative in its money creation; its behaviour is tempered by an hysterical investment community that mechanically associates QE with inflation. Indeed, applying Mr Taylor's rule, the US central bank recently concluded that the fed funds rate should be minus 5 per cent today. The Fed might need to print as much as $10,000bn to counteract the slump in dollar wealth; none of us really knows the true figure. However, if the 1930s are a guide, the economy is likely to remain weak. For government bond yields are rising. This year, the yield on the US 30-year bond has risen from 2.5 to 4.3 per cent, near its two-year average. Remember that in 1931 such action presaged the economic collapse of 1932. This was the Milton Friedman/Anna Schwartz critique: that an activist central bank should have countered the destruction of dollars by printing new ones through quantitative easing. But it did nothing. The rate of liquidation intensified as earlier hopes of an economic rebound dissipated. And so to gold bugs and bond bears I say, enjoy your fun: it is only a question of time before this tighter monetary policy stops the second derivative improvement in the economy in its tracks. Like I said, I'm bullish on bonds. The writer is chief investment officer and founding partner of Eclectica Asset Management