Many investors are afraid of inflation because they understand the run-up in prices will take a big bite out of their wallets – and their buying power.

While that’s a valid concern, I’m much more worried about one of the other possible fallout effects of the expected inflationary surge – the potential for the worst global bond rout in nearly 20 years.

But here’s the thing: Even if that happens, it doesn’t have to hurt. In fact, you can turn it into such a big profit that even the inflationary pressures will seem like a minor nuisance.

Deja Vu All Over Again

The last time we experienced anything like this was back in 1994. And the surrounding circumstances at work back then were remarkably similar to those we face now. Bond yields were at historical lows that year, company wages were flat, and we were in the midst of an unprecedented 34-month economic expansion.

Fortune estimated at the time that yields on the 30-year U.S. Treasuries – which rose from 6.2% at the beginning of the year to 7.75% by September – cost U.S. bondholders more than $600 billion and global bondholders as much as $1.5 trillion. (Those losses are listed in 1994 dollars; if we convert them into current-day dollars – even using the federal government’s dubious inflation statistics – those losses would be $888 billion and $2.2 trillion, respectively.).

[ad#Google Adsense]I grant you that those are staggering numbers. But they pale in comparison to what’s on the line today.

As I noted in a Money Morning column late last month, the total value of the global bond market is presently estimated to be $80 trillion, with the U.S. accounting for roughly $31 trillion to $34 trillion – or 39% to 43% of the world’s securitized debt.

Investors constantly tell me that “things are different now,” and insist “this could never happen today.”

As the late great investor Sir John Templeton liked to say: “The four most dangerous words in investing are: ‘This time it’s different’.”

In fact, I’ll even say this: Investors who claim we could never have a reprise of the 1994 global-bond-market meltdown are deluding themselves.

We are today securitizing ever-larger chunks of the global economy with everything from credit-card debt to home mortgages – which we’re then selling into larger and larger pools of assets.

The upshot: There are now trillions of dollars of “derivative” assets involved in the mix, and the bond markets are no longer the “safe haven” investors have long thought them to be. In fact, this once-stodgy hangout for fixed-income investors have been transformed into huge speculative pools for the self-anointed Wall Street “masters of the universe” who traded the rest of us to the brink of financial oblivion in late 2007, and who are once again on the hunt.

The Farcical Fed?

I’m not alone in this view, with such investing notables as Dr. Marc Faber, Jim Rogers, Pacific Investment Management Co. LLC’s Bill Gross and others all observing the potential for a massive correction once traders take interest rates into their own hands.

In fact, JPMorgan Chase & Co. (NYSE: JPM) Chief Economist Bruce Kasman – a former Federal Reserve Bank of New York official – told Bloomberg News that “there is a recipe for disruptive dynamics in markets if policy adjustments have to gather steam in a synchronized way.”

Put in plain English, bonds could get clobbered if traders doubt the capabilities of the U.S. Federal Reserve – and if the U.S. central bank is forced to start raising interest rates before policymakers really want to do so.

When I’ve warned of this scenario in the past, I characterized this as a “potential” outcome. Now it seems like more of a certainty. The only question is … when ?

Most investors acknowledge this – even if that realization is hidden in some deep, dark recess of their brains. But what many are missing in their quest to second-guess the Fed is that, this time around, the catalysts are events that are actually taking place thousands of miles from our own shores.

As I’ve noted here in Money Morning on several prior occasions, the only reason we’ve been able to stave off inflation in the face of $14 trillion debt and a Fed that wants to keep interest rates artificially low is that our nation has been able to offload inflation to China, India and other emerging-market economies where monetary policy could absorb our own special brand of export: f iscal lunacy.

Ironically, this has all been okay at least as long as the developed world kick-started everybody else. But now that the emerging markets represent a third or more of the world’s economic might, you have a very different story.

For instance, it’s no longer inconceivable if things really get out of hand that yields on our own 10-year Treasury notes could zoom to 10% in the next 24 months, an increase of 183% from the 3.53% yield the notes were trading at on Monday. The odds of such a scenario aren’t high. But it’s not impossible, either.

My “trader’s forecast” stands as a complete contradiction to the expectations of Team Fed and legions of economists who are forecasting a subdued bond-market decline that sends yields up only to 4.25%, according to Bloomberg.

The way I see it, the tiger has already escaped his cage and is on the prowl. Fifteen of the 20 emerging-economy countries my team and I watch are already raising rates to cope with higher inflation – chiefly the food and oil prices that are either nearing, or in, record territory.

Normally, raising rates in the face of inflation is a good thing. But the danger here is that the central bankers around the world aren’t raising rates enough – particularly in the China-dominated Pacific Rim. And that could come full circle to bite U.S. investors.

According to Bloomberg data, eight of 14 countries in the Asian-Pacific region are running negative real interest rates. This is especially problematic because a negative real interest rate means that the rate of inflation is greater than the central-bank-set interest rates.

This matters – and hang with me on this – because negative real rates, although relatively rare in the annals of global financial history, essentially steal money from savers in order to “subsidize” debtors. Over time, this engineers an involuntary redistribution of wealth from those who have been responsible with their assets to those who haven’t.

You see, central banks tend to manipulate interest rates in the interest of self-preservation – especially when it comes to the short-term interest rates that are arguably the most “controllable.” In practical terms, these central bankers will drive short-term rates down below the prevailing rate of inflation, which means that savers actually lose real purchasing power – hardly a reward for the savers’ prudence.

I’ll admit this is a pretty abstract concept, so here’s an example that might help. If you lend $10,000 in 2011, it might be worth $10,100 in 2012 – even though the same money is only capable of purchasing $9,900 worth of goods or services.

And that leaves investors in quite the pickle: Should they “lend” money to those who will squander it, or do they hoard their cash in an attempt to save it from central bankers and politicians who don’t seem to understand (or even care) that giving money away ultimately destroys our economy as well as the economies of our trading partners?

History shows the Fed is pretty much damned either way. If it continues to take money from the private sector under the guise of engendering growth, it risks crushing investors via short-term rates that will ultimately rise. Everything from adjustable-rate mortgages (ARMs) to credit-card debt will be affected.

If the Federal Reserve doesn’t rates interest rates, the money that U.S. President Barack Obama and Team Bernanke desperately want spent here will continue to migrate to other capital markets where interest-rates are higher (and rising) and more reflective of actual growth.

Moves to Make Now

Negative-real-rate environments traditionally support investments in gold, silver and other commodities, since assets of those types help hedge the very real loss of purchasing power that accompanies them. Agricultural choices are solid, too – especially with food costs at record levels around the world.

Two of my favorite investment choices of this type are the SPDR Gold Trust Exchange-Traded Fund (NYSE: GLD) and the MarketVectors Agribusiness ETF (NYSE: MOO).

[ad#article-bottom]I also happen to like exchange-traded notes (ETNs) that are tied to the Rogers Commodities Index created by the afore mentioned legendary investor. Two include the Elements Rogers International Commodity Index Total Return ETN (NYSE: RJI) and the Elements Rogers International Commodity Energy Total Return ETN (NYSE: RJN).

I know that the run in such choices has already been significant with gold trading at near-record levels, oil punching through new highs almost daily and agricultural commodities also flirting with never-before-seen prices in many parts of the world, but the fact that we have seriously negative real rates of return around the world suggests we’ll continue to see growth in those asset classes for some time to come.

Then the real fireworks will begin – when everyone else (those who don’t read Money Morning) realizes we’ve all been had by misinformed central bankers who thought they understood the laws of money and who enabled the very conditions that will make $200 a barrel oil and $2,500 gold seem like bargains in the rearview mirror.

Actions to Take: Inflationary pressures continue to spiral – even in the face of interest rates that are being held at artificially low levels by central bankers in the United States and other select countries. The upshot: Fixed-income investors who view the bond markets as a stodgy safe haven from the nasty price swings and wrenching volatility of the “evil” stock markets are in for the surprise – and the financial thrashing – of their lives.

You don’t have to make that same mistake.

In fact, if you recognize certain financial truisms, and invest accordingly, you can at least protect yourself from this thrashing, and possibly even profit from the thrashings that other investors (who refuse to acknowledge reality) allow themselves to undergo.

As an investor, make sure that you understand that periods of negative real interest rates:

  • In the long run are deadly for fixed-income investments such as bonds.
  • Traditionally support investments in gold, silver and other commodities, since assets of those types help hedge the very real loss of purchasing power that accompanies negative real rates. Oil and agricultural commodities can play the same role – especially with food costs at record levels around the world.

Precious metals, oil and agricultural commodities can be used to hedge against – or downright offset – a bond-market rout ignited by negative real rates.

Among the many investments that can be deployed in such an environment, four merit special mention. There is:

  • The SPDR Gold Trust Exchange-Traded Fund (NYSE: GLD) for gold.
  • The MarketVectors Agribusiness ETF (NYSE: MOO) for agriculture.
  • The Elements Rogers International Commodity Index Total Return ETN (NYSE: RJI) for a broad exposure to commodities.
  • And the Elements Rogers International Commodity Energy Total Return ETN (NYSE: RJN) for energy.

— ¬†Keith Fitz-Gerald

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Source:  Money Morning