Let’s begin with the news…and then a bet.

First, the stock market bounced yesterday…following Friday’s fall. The Dow rose 70 points. The dollar bounced a little too – closing at $1.56 per euro. Gold held steady at $898. And oil gave up $4.

Now the bet…

Fortune magazine reports that Warren Buffett has bet a hedge fund management business that it will not outperform the S&P 500 over the next 10 years. The firm, Prot̩g̩, is in the business of running hedge funds, and has done well. Since 2002, it has made investors 95% on their money Рafter fees. By comparison the S&P 500 is up only 64%.

But Buffett is confident that the combination of high fees and regression to the mean will doom Protégé. So the two bought a 10-year zero coupon Treasury bond. At a cost of $320,000, the bond will be worth $1 million when the 10 years are up and will be given to the charity of the winner’s choice.

Who will win?

Our money is on Buffett. We’ve described in these pages why hedge funds are a losing proposition for investors. Over time, the managers’ performance regresses to the mean of all investment advisors – which is to say, he gets about the same as the broad market itself. And over time, the effect of taking out large fees to pay the managers – typically, 2% of principal and 20% of performance – reduces the investor’s capital.

Mathematically, if you leave your money in a hedge fund long enough it will all end up with the manager.

But we will make a further wager: we bet that both bettors will lose. Here’s why:

The have bought a Treasury bond.

We did not look this morning, but the last time we took note of it, the yield on the 10-year Treasury was less than 4%. And the last time we looked, the official consumer inflation rate in the United States was over 4%. Of course, that’s just the beginning of the inflation story. The real cost of living is going up faster than the Labor Department numbers tell. Producer prices…import prices…raw material prices…oil prices – all the numbers that eventually make up the CPI are going up much faster than the official CPI rate itself. And every time anyone from outside the government tries to calculate consumer inflation, he comes up with a number considerably higher than those Labor Department statisticians give us. For example, when newspaper reporters bought the ingredients for a traditional Memorial Day cookout, they found them about 10% more expensive than a year before.

Inflation has gone global. It’s officially 8.5% in China. In Russia, it’s 14%. In Vietnam, it’s 24%. And in Zimbabwe – it’s gone to the moon.

How is it possible that inflation in the United States – which imports so much stuff from the rest of the world – can remain so low? “Seasonal adjustments” is the standard explanation.

But the seasons change. Our guess is that cold winds will soon blow across the borderline…and those greenback leaves will turn brown…curl up…and blow away.

Ben Bernanke and Hank Paulson both announced that a strong dollar was something America wanted. Bernanke even led investors to believe that perhaps rate hikes would follow. But then, last week, the unemployment rate in America jumped to 5.5%, its biggest increase since 1986. Central banks do not increase rates when unemployment is rising. Nor, speaking very broadly, do central banks increase rates when the government is $57 trillion in the hole.

Since Ben Bernanke is not going to defend the dollar, globalized inflation is bound to result in higher inflation rates in the USA…probably sooner, rather than later. And while it is impossible to predict the future…it is quite possible to imagine a world 10 years from now when the $320,000 Warren Buffet and Protégé spent on their T-bond will be worth less than $320,000 in today’s money. It is not such a stretch to think that $1 million in 2018 will be worth less than $320,000 today.

So, here’s our bet: Buffett will beat Protégé, but inflation will defeat them both. An ounce of gold is $898 today. At that price the two paid 366 ounces for their T-bond. They will have $1 million ten years from now. Our bet is that $1 million won’t buy 366 ounces of gold in 2018.

Bill Bonner
The Daily Reckoning