Prices in the bond and commodity markets centered around thisquestion: "Will there be inflation in 2012?" And the answer in mostmarkets was, "No, probably not."
Inflation is the enemy of bondinvestors, because it erodes the value of a bond's fixed interestpayment. When inflation is the air, traders push bond yields up andprices down. And commodity prices are a real-time indicator of inflationin everything from copper to gold to grain.
Despiteworries that the Federal Reserve's easy-money policies would drive upinflation - and that the nation's rising debt would intensify that -inflation was remarkably restrained in 2012. The government's consumerprice index rose just 1.8% the 12 months ended November, according tothe Bureau of Labor Statistics.
Most commodity prices confirmedthat. For example, the Commodity Research Bureau index, which reflects abroad basket of commodities, fell 7.7% in 2012. The average price ofunleaded gasoline at the pump fell 0.5%, to $3.276 a gallon, accordingto AAA.
But precious metals investors are still true believers ininflation, and have been pushing prices up all year. But even gold bugslost conviction in inflation: A late-year sell-off in the yellow metaltrimmed those gains, however, and gold closed the year at $1664.00 anounce, up 5.4% from a year earlier.
The bond markets also showed little fear of inflation.
Thebellwether 10-year Treasury note's yield ended 2012 at 1.76%, just abit lower than where it was at the start of the year. Investorscollected meager interest and got a tiny bit of price appreciation -bond prices rise when yields fall, and vice versa.
The iSharesBarclays 7-10 Year Treasury ETF, which invests in Treasury notes thatmature in seven to 10 years, gained 4.1% with dividends reinvested,according to Morningstar, which tracks the funds.
Treasuriestypically have the lowest yields in the bond universe, because investorsfigure there's no chance that the government will default on its debt.And the Federal Reserve helped keep Treasury yields low throughout theyear, in a bid to stimulate the economy.
The bond market favored the bold in 2012, but taking more risk for higher yields is always a risky strategy.
Thosewho invested in high-risk junk bonds - IOUs issued by corporations withdubious credit rankings - gained an average 14.6%. These bonds areeconomically sensitive, just as stocks are. Should the economy dive,more shaky corporations will default on their debt, and junk investorscould get hurt.
Bond yields typically rise when traders thinkinflation is in the air: Rising inflation erodes the fixed interestpayments that bonds make. So far, at least, the bond market sees littleinflation ahead.