Financial advisors and their clients could face a bull market at the long end of the yield curve if deflation makes a comeback. Although that may seem ironic, given that inflation has returned to the front end of the curve, the case for deflation is influencing cautious bond inves-tors to move their money into mid- and long-term bonds in the expectation that 20- and 30-year interest rates will decline when the recovery euphoria abates and exposes what remains a troubled global economy.

That Canada and the U.S. can have long-term disinflation, or even mild deflation, is rooted in the idea that focusing on headline inflation is wrong. With light sweet crude oil at about US$100 a barrel in early May, Canada’s consumer price index is due to rise by 2.8% in 2011 and by 2.3% in 2012, suggests Bank of Nova Scotia’s economics department. But that’s in the short run; if energy costs remain high, they will act as a tax on household spending — or be a hike in general production costs.

Chris Kresic, partner and co-head of fixed-income with Jarislowsky Fraser Ltd. in Toronto, agrees: “High oil prices create a potential for disinflation through demand destruction.”

Commodities prices — although up by about 10% year-to-date — have weakened as investors have moved away from inflation hedges. Cautious investors have gotten out of silver, fearful that its bubble could pop. But high oil prices remain a force capable of bringing on deflation.

“Oil is a double-edged sword,” says Jack Ablin, executive vice president and chief investment officer with BMO Harris Private Bank in Chicago. “It is a tax on consumers and a boost in production costs.”

The Bank of Canada is squarely in the middle of the problem. Rising headline inflation rates, soaring corporate profits and falling unemployment would ordinarily prompt the BofC to raise interest rates; but with the loonie trading at a 3% premium to the U.S. dollar, BofC governor Mark Carney seems in no rush to injure exporters that price their goods in Canadian dollars.

High oil prices mean less industrial production — and that, of course, is synonymous with recession. The irony is that this potential recession would be accompanied by a strong C$. The loonie, high relative to the greenback, reflects strong export demand for commodities; however, it also cuts foreign demand for Canadian-manufactured goods priced in C$.@page_break@Put all that into the macroeconomic blender and the result is abundant money pouring into energy companies’ stocks. Bank shares also gain, as a momentum play on rising bank earnings — and perhaps as a bet on the BofC’s eventual admission that interest rates must rise.

Profitable resources companies won’t need to borrow money. The also-ran manufacturers and consumer-products companies won’t need much money for expansion; if their businesses are really poor, the bond markets won’t give it to them. This is the case for declining demand for loanable funds, in which the price of money — that is, interest — drops. Bond prices will rise as investors quit stocks and head for safety. It is recession’s prologue.

The case for slowing inflation, perhaps deflation, rests on the weak support for the U.S. recovery, says David Rosenberg, chief economist and strategist with Gluskin Sheff & Associates Inc. in Toronto. He had predicted the U.S. housing bubble would burst long before it did. And while U.S. unemployment remains high at 8.7% but down from 9.6% in 2010, he suggests it’s unlikely to go much below 8.2% next year. The U.S.’s unit labour costs are falling — and declining unit labour costs have an 80% correlation with inflation, he notes. Add to that the likelihood that home prices may fall by another 20%, and the case for reduced consumer spending is strengthened. It is a recipe for a contraction of the U.S. economy.

Betting against the global recovery — and that high oil prices are a net benefit to Canada — would seem to add risk to a portfolio. The rationale for buying long bonds as a covered bet on declining interest rates is that high oil prices are here to stay and that those prices hurt the U.S., the world’s biggest importer of oil. As the U.S. goes, so Canada goes.

Putting money into long bonds as yield insurance and as a bet on falling long interest rates is not a consensus position. The steep yield curve currently indicates an expectation of rising, not falling interest rates. Long-term protection against declining inflation is inexpensive. A 30-year Government of Canada bond due June 1, 2041, has recently been priced to yield 3.59% to maturity. That’s not much of a yield boost over a 20-year Canada bond due June 1, 2033, that yields 3.52% to maturity.

A cautious bet would be to buy a provincial bond with an approximately 80-basis-point yield spread over Canada bonds of similar term. An Ontario coupon due Dec. 2, 2024, recently priced at $54.86 per $100 face value, yields 4.48% to maturity. It will gain 13% in price for every percentage point drop in interest rates. It’s a bet a bond investor can’t lose: if the bond is held to maturity, it will pay $100 with a locked in gain of $45.14.

This is an inexpensive way for your clients to get an inflation hedge that matures soon enough to be meaningful — and a shot at making substantial profits if interest rates fall in the next decade. It will work with any strip with more risk and more potential gain as the term of the strip lengthens. IE