By Michael Pento 

The bond market is screaming something loud and clear as we close out 2007 so brace yourselves for the expected volatility of next year. Fixed income traders are bellowing with resounding clarity that a recession is around the corner and inflation is nowhere in sight.

Yet, the current Ten year Treasury note is yielding only 4.11% down from its high of 5.25% reached in June of this year. While Treasury Inflation Protected Securities (TIPS) bear a yield of 1.90%. That is up fifty basis points from 11/26 and renders the current TIPS spread to just 2.21%. What this tells us is that traders of this instrument expect that inflation will average only 2.21% over the next 10 years!

Why should this be puzzling for investors? Because the latest read on inflation issued from the B.L.S. showed that overall consumer inflation hit a 2-year high after registering a year-over-year increase of 4.3%. It is certainly not from empirical data that bond investors view inflation as quiescent. What, then, is the reason the 10 year note is yielding well below the current rate of inflation--even before taxes are taken into consideration? The resounding conclusion must be that bond traders expect a severe downturn in our G.D.P. and that a recession is coming which will be so severe as to eviscerate inflation fears.

So, we find ourselves in this odd environement in whic inflation expectations are falling while actual readings on inflation are rising. I find this view hard to reconcile with the inflationary monetary actions being taken by Central Bankers from the U.S. to Canada, Europe and the U.K., but I must simply believe the bond market's conclusion on G.D.P. to be correct.

However, where we differ is in their judgment about inflation. What central banks are clearly underestimating is the elevated chance of a stagflationary environment arising in 2008, reminiscent of the one that plagued the Carter administration in the 1970's.

Listen, investors should take heed of what the bond market is prognosticating in regard to economic growth. However, it would be a mistake to overlook the inflationary implications of the Central Bankers' mission to monetize away the problems associated with housing, not to mention their ability to make those problems disappear.

*If worried about these elevated inflation readings and their potential impact on your assets, you can click here to learn about the Inflation Protection Portfolio I manage at DGA.

Michael Pento