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9. The broad CPI (including food and energy). Overall CPI will probably average between 4.0%-5.0% during most of the next decade, with brief spikes up to around 8.0% not unlikely.10. Risks from US Treasury Bond market. An acceleration of the core rate of inflation to the 3.0% to 4.0% range suggests 10-year US Treasury yields in the 5.% to 6.5% range, with the possibility of some temporary spikes beyond that range. The real exchange rate adjustment mentioned earlier could pose further challenges to US Treasury bonds as foreign investors demand higher yields to compensate anticipated Dollar depreciation. A rise in nominal interest rates of the aforementioned magnitude could be absorbed by the US economy if it is sufficiently gradual. As long as capital markets aren't seriously destabilized and the US economy continues to grow, corporate fundamentals in the US will improve. Therefore money should flow to non-treasury debt thereby compressing spreads which are still quite high, thereby mitigating the rise in the risk free rate. Also, it is important to remember that it is ultimately real interest rates that really matter. If history is any guide, the rise of real yields on long-term debt should lag the rise in nominal yields. Such a scenario could actually prove quite stimulative to the economy in the medium term. ConclusionMake no mistake about it. The full implications of my predictions regarding accelerating cyclical growth and concomitant commodity price inflation, combined with the secular trend toward imported inflation, are quite profound, if not revolutionary. What I'm talking about is nothing less than the reversal of secular trends that have spanned two to three decades. Most people working in financial markets today have simply not known such an environment. It will be a shock. The risks of commodity price spikes should be accentuated between April and September of 2010 and the broad CPI could surpass 3.0% by the end of the year. However, it probably will not be before mid 2011 that core inflation rates could break out of their 15-year range of approximately 2.25% to 2.75%. The question is how exactly financial markets and policy makers will deal with these cyclical and secular developments. I think it would be foolhardy of me to make such a long-term prediction at this point. Such predictions can only be reliably made, if at all, once the ground starts shifting and one has been able to observe the initial reactions of policy makers and financial markets participants. A doomsday scenario is neither necessary, nor even likely. Furthermore, I can envision many scenarios in which the US economy does quite well in an environment of moderately accelerating inflation and rising nominal bond yields. However, in the event that my predictions regarding cyclical and secular forces leading to higher inflation prove prescient, the situation will become quite fluid. You could even call it scary. As reported last week, I’m studying investment options such as: Long SPDR S&P 500 (SPY), PowerShares QQQ (QQQQ), and iShares Russell 2000 Index (IWM). Short SPDR Barclays Capital 1-3 Month T-Bill (BIL), iShares Barclays 1-3 Year Treasury Bond (SHY), or iShares Barclays 20+ Year Treas Bond (TLT). Long UltraShort 7-10 Year Treasury ProShares (PST), UltraShort 20+ Year Treasury ProShares (TBT). Long SPDR Barclays Capital High Yield Bond (JNK) and iShares iBoxx $ High Yield Corporate Bd (HYG). Long PowerShares DB US Dollar Index Bullish (UUP). Old favorites such as Apple (AAPL) and Bank of America (BAC) could fly in such an environment. Investment banks such as Goldman Sachs (GS) and Morgan Stanley (MS) should rock as underwriting activity and M&A heat up. The tech space in general looks very attractive including chips and networking. Economically sensitive cyclical stocks should do well but timing will be key as major events in the bond markets and China loom. Brazil and Asia, excluding China and Japan, look particularly good in the emerging markets space. Finally, gold-based investments such as SPDR Gold Shares (GLD) and Market Vectors Gold Miners ETF (GDX) should remain in a sweet spot.
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