Montreal, Canada

Can deflation and inflation assets co-exist? Can both assets rally in unison, despite harboring completely divergent asset class outcomes in wildly different economic environments?

Since the onset of the credit crisis three years ago, more often than not, gold prices and Treasury bonds have rallied simultaneously; brief periods showed negative correlations, including July 2008 through November 2008 and throughout most of 2009, which followed a crash in bond yields after hitting their lowest levels since the Eisenhower administration in December of 2008.

After seven months of trading in 2010, gold prices and U.S. benchmark ten-year Treasury bonds have exhibited a higher correlation than historical behavior would suggest. That's bizarre market action because gold acts as a traditional inflation hedge while bonds are regarded as primary winners amid accelerated disinflation (e.g. 1990s) and deflation (e.g. 2008, 1930s). It's almost like cats and dogs enjoying each other's company when we all know they don't get along.

Through July, gold and bonds have rallied together in five out of seven months with January and July the only disconnect. Both asset classes also rank as one of the few investments to rise in a tough market this year; Treasury bonds have gained 6% this year as measured by the Vanguard Total Bond Fund and gold prices are up about 7%.

Perhaps a greater explanation for this largely positive correlation in 2010 lies in the growing fear that we're entering outright deflation again. Gold is a store of value in uncertain economic times – including price deflation. It's simply not true that gold must decline as nominal and real prices fall in value.

Consumer prices remain in positive territory in the United States but just barely with June CPI up 1.1% year-over-year. But in Europe, a few countries are now experiencing negative inflation or deflation, including Ireland and Spain. This is consistent with the resultant effects of housing deflation in these countries and, increasingly, it appears to be spreading to the United States.

Bubbles in housing, however, remain in Canada, Australia and parts of China.

Gold, which now commands the attention as a surrogate currency in the age of rapidly rising government deficits and weakening fiat currencies, is showing its metal (no pun intended) as a store of value as governments flood the system with debt obligations. It's also noteworthy to mention that broader monetary aggregates in the West and Japan have literally fallen off a cliff this year – again, a deflationary event suggesting central banks are losing the war on credit growth and rising inflation.

Gold, contrary to popular wisdom, is rising in a deflationary environment just as it did in 2008.

High quality bonds and gold are the new anomaly this year. Both assets should harbor a strong negative correlation but, instead, appear to be running together. I suspect this odd relationship will continue until the bond vigilantes attack Treasury, at which time I expect gold prices to head off to the next solar system or, what I would term, the "meteoric phase." That'll mark the endgame of the "flight-to-safety" trade in T-bonds and the nadir of the secular bull market in gold.