Wednesday, April 21, 2010
The market—which reflects the cumulative wisdom of billions of participants—is pretty good at discovering information and pricing things efficiently. I think there is great value to be found in market pricing, which is why I pay a lot of attention to things like the value of the dollar, credit and swap spreads, gold, commodities, the shape of the yield curve, and the implied volatility of options. But the market can and does make mistakes. One case in point is the bond market's ability to correctly anticipate future inflation.
I think these two charts provide evidence of the bond market's fallibility when it comes to inflation forecasting. If the bond market were an excellent judge of future inflation, then interest rates would always, after the fact, offer investors a yield that exceeded inflation. Real yields, in other words, would tend to be somewhat positive most or all of the time.
The first chart focuses on the past 50 years of interest rates and inflation. Note that in the early 1960s, when inflation was very low and stable, bond yields were also low and stable, but also consistently higher than inflation. Around 1965 inflation started rising, and bond yields struggled to keep up. If you bought the 10-yr Treasury bond in 1970 it yielded about 7%, but inflation over the next 10 years proved to be almost 8% per year. T-bonds were a lousy investment in real terms throughout the 1970s.
The bond market finally learned its inflation lesson by the early 1980s, as 10-yr Treasury yields soared to 14%. Once burned, twice shy: no one was going to be foolish enough to trust their money to the bond market unless they received a handsome premium over inflation, which was expected to be in the double digits for the foreseeable future. However, thanks to tough monetary policy from the Volcker Fed, inflation subsequently collapsed. As a result, real yields were enormous in the 1980s, and investors in T-bonds earned huge real returns (I should know, as I was lucky enough to buy 30-year zero coupon Treasuries in 1982 and 1983 for my IRA account—an investment which more than tripled in value over the next 10 years).
In short, the bond market underestimated inflation throughout the 1970s, and overestimated inflation throughout the 1980s and 1990s.
The second chart shows real yields (the difference between 10-yr yields and consumer price inflation) over a very long time horizon. As should be obvious, the bond market made some huge inflation-forecasting mistakes in the 1930s and 1940s.
On average, real yields on 10-yr Treasuries have been 2.6% per year since 1925, and that's the value that the market seems to gravitate around. But note how real yields have been for the most part below average since the early 2000s. Not coincidentally, monetary policy has been for the most part quite accommodative over this same period. The Fed has been unconcerned about inflation, and so has the bond market. I believe that is still the case today. Both the bond market and the Fed are underestimating future inflation, just as they did in the 1970s.
Why? Because the bond market pays too much attention to growth, and not enough to sensitive prices. Because the Phillips Curve theory of inflation is still dominant, despite having been disproved countless times over the years. See my many discussions of this here if you want more background.
Posted by Scott Grannis at 10:21 AM