Shadow of 1970s inflation starting to worry bondholders

NEW YORK (Reuters) - Surging energy and food prices are likely to underpin a further rise in U.S. bond yields in the near future, even if yields do not rise to the extent they did in the 1970s and 1980s.

U.S. Treasury bond yields rose above 15 percent in 1981, after U.S. consumer prices rose at more than 14 percent a year, in the wake of the inflationary effects of 1970s oil price shocks when crude oil prices tripled to over $9.00 a barrel.

"Even though I can't imagine our economy going to the same situation as in the 1970s, some form of stagflation may crop up," said Jonathan Lin, senior analyst with Louise Yamada Technical Research Advisors LLC in New York.

Stagflation, or anemic growth combined with high inflation was last seen in the United States in the 1970s and early 1980s. Now, some economists believe it has already returned.

Since 2000 oil prices have quintupled from around $30 a barrel to nearly $150 a barrel, while U.S. inflation has risen to over 4.0 percent per year, and the benchmark U.S. Treasury bond yield has risen to around 3.90 percent.

Rising bond yields are likely to raise borrowing costs for corporations and consumers, at a time when banks are reducing lending in the wake of the global credit squeeze of the past year.

While the U.S. and European economies are seeing economic growth slow this year, thanks to the credit crunch and soaring energy prices, demand from emerging markets is likely to keep oil prices high, analysts said.

Meanwhile, a slowing U.S. economy may continue to undermine the U.S. dollar in which oil is priced and provide another reason for oil prices to rise further.

The U.S. economy's dependence on oil may not be as great as three decades ago, and a domestic wage-price spiral has yet to materialize, but these factors may not be enough to cushion the United States from global inflation pressures, analysts said.

"The old world is in stagflation because the new world is in inflation." said Jan Loeys, head of global asset allocation with JPMorgan in London.

Developed countries such as the United States are already suffering from stagflation, albeit not as extreme as three decades ago, he said. Meanwhile, China, India and other emerging economies are driving global inflation pressures.

"The new world is booming and competing for the resources by bidding up the price, while the old world has its problems with ageing populations and falling productivity which is depressing growth," Loeys said.

The closest comparison is the 1970s, he said.

Now, record gasoline prices and escalating food costs will likely push annual U.S. consumer price inflation above 5.0 percent in August this year, from 4.2 percent, some economists forecast.

Before early 2002, oil prices and the 10-year Treasury note yield showed some correlation, as both respond to inflation and inflation expectations, said Lin.

But that correlation has since broken down, because of aggressive interest rate cuts from the Federal Reserve which have dragged down bond yields and contributed to the boom in commodities, he said. The correlation may not come back, but a bond market selloff could still happen, he said.

The first sign that a situation more akin to the U.S. stagflation of the 1970s and early 1980s was taking hold would be a move of the 10-year Treasury note yield above 5.5 percent; the upper end of its range over about the past six years, Lin said.

Real interest rates are already negative with the 10-year yield at 3.90 percent, below the U.S. consumer price index, currently at 4.2 percent. If that gap should widen substantially at the same time the dollar falls steeply, this could herald a more intense stagflation problem.

Risks to the U.S. dollar have risen with the travails of mortgage finance giants Fannie Mae and Freddie Mac, who own or guarantee $5 trillion in debt, close to half the value of all U.S. mortgages and slightly more than the size of the U.S. government bond market.

Analysts worry that if the U.S. government's plan to shore up the mortgage firms, announced on Sunday, triggers hefty debt issuance that could cause Treasury yields to spike higher and chill foreign demand for U.S. government bonds, punishing the dollar.

An anticipated long term dollar decline of more than 25 percent in the New York Board of Trade's dollar index .DXY over the next few decades may exacerbate inflation and induce foreign central banks to start selling their U.S. Treasuries holdings, Lin forecast.

China and Japan combined hold more than $1 trillion of U.S. Treasury securities: over a fifth of the $4.67 trillion outstanding.

But stock markets may also fare badly, if inflation accelerates and becomes ingrained.

"Stagflation is known to leave investors with few easy investment options, aside from commodities," Loeys said.

"What we have seen in the 1970s is that bonds underperform cash and cash underperforms inflation. Equities were just about equal to cash, so you did not get positive real returns for the whole decade: pretty dismal," said Loeys.

That investment environmment has returned in the first half of 2008, with inflation outpacing the returns from cash, bonds and equities, Loeys says.

But he does not expect the U.S. 10-year note yield to spike dramatically, unless foreign central banks stop buying Treasuries. Its yield should rise to about 4.50 percent next year. "If 10-year Treasuries move up 50 basis points that's not a disaster. It means you don't get any return (above inflation)," Loeys said.

(Reporting by John Parry;)