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.
Yes, I fully agree. The rates on bonds have a history of reflecting investor sentiment. When fear is high Treasury yields are lower than they should be. And when yields rise it is generally do to investors chasing equities which investor sentiment believes at the time offers higher returns. There is an inflation overlay, but high inflation drives rates lower due to the fear effect of being in equities and not knowing what to do.
ReplyDeleteI agree that the connection between inflation and yields for bonds is almost inverse.
What inflation?
ReplyDeleteWorker productivity continues to rise handsomely. Wages are dead.
Real estate of all kinds is soft.
Powerful deflationary shock waves were sent through the economy by the near-death experience of the stock market and property market collapse of 2008.
Office buildings are half-price in SoCal. Warehouse space cheaper too. Housing is half-off from the peak.
The prices of manufactured goods is generally down, not up (except for military hardware).
It is cheaper to run a business in SoCal than three years ago, due to these reasons. Rents are falling yet for apartments and office buildings.
Commodities lost their murky predictive value (in regards to US inflation) somewhere in the last 10 years due to China demand and speculation.
OPEC and thug state kooks control oil supplies--they rise and fall depending on what lkunatic does what. Chavez has taken a lot of oil off the market by wrecking the Venezuelan oil industry. This has nothing to do with Fed policy. Ever hear of OPEC?
Gold is gold. Chinese love to buy gold, and they have disposable income now. If gold was a predictor of inflation in the USA, one would expect it to surge from 2000-2008, and then tumble. Instead, a fluff-bubble happened after 2008.
Expect low, and then lower interest rates ahead. There is a glut of capital in the world. Investors who want safety will have to settle for small negative real returns.
This should set up for a rally in stocks and property, especially in Asia.
Seeking,
ReplyDeleteMaybe I'm missing something here but I'm not interpreting Scott's point as an inverse relationship between inflation and interest rates. I am thinking that it IS inflation that causes rates to rise as bond investors demand more income to offset it. Thus the relationship is correlated strongly.
One other thing. In my experience the vast majority of bond money is NEVER going into a stock, but a LOT of stock money will DEFINATELY go into bonds during periods of fear. It waxes and wanes, of course, but I'm not sure about bond sellers running to the stock market is the biggest factor in yields rising. I tend to think high inflation drives rates HIGHER instead of lower.
Benj,
ReplyDeleteI think you have it pegged pretty good....for right now. And likely for an indefinate time into the future. However, it has been my experience that the one thing that can be counted on in spades is CHANGE. Nothing stays the same for extended periods of time. Especially in the markets. Thus I am always asking myself 'what is going to be different in one to two years that the crowd is not seeing?' If that question is answered accurately (TALL order) then one can so position himself to benefit. Bet big enough, and hit it, and fortunes can be made. Soros & Rogers did it with the British Pound twenty or so years ago. Paulson did it just recently with his bearish housing bet. Now I'm not interested in betting THAT big but I do think something that is worth thinking about is the POSSIBILITY that the big change in the rate of inflation over the next two years or so is a snake not many are seeing right now.
I make no claim to clairvoyance and it is certainly not KNOWABLE with certainty how the inflation rate is going to change. By anyone. But for me, the developing evidence is beginning to point toward a slowly rising inflation rate over the next several quarters, and I am beginning to increase my hedges to participate.
I initiated a long position today in Potash of Saskatchewan, a Canadian fertilizer manufacturer that supplies global markets (including China). I have no clue what the stock will do in the near term. If it weakens, I plan to add to my small initial position. If the inflation rate rises, fertilizer prices will likely rise also, as will the stock price. Even if inflation stays tame (a very possible event) the world's desire for a better diet should increase demand for grain based feeds, which of course require fertilizers.
Just an example of how I utilize Scott's charts and interpretations.
Shouldn't you have compared 10-year bond yields to the next 10 years of inflation. I don't know if that will change anything, but it seems a more fair comparison.
ReplyDeleteI did do that, comparing yields in 1970 to the average inflation rate over the next 10 years. From 1980 through 1990, yields were obviously higher than subsequent inflation.
ReplyDeleteSG: "The market—which reflects the cumulative wisdom of billions of participants—is pretty good at discovering information and pricing things efficiently."
ReplyDeleteI think you unintentionally explained the problem ... the market does not reflect billions of opinions.
Even in the best of times, it reflects perhaps a few million opinions world wide. The pension fund "votes" the opinion of the fund manager only, not the opinions of the pensioners. Ditto for insurance companies, mutual funds, etc. In the best of times, a very small subset of the population sets market prices.
In recent years -- price discovery has completely broken down. Left to their own devices, the price of every major bank should be zero. A non-economic entity (Henry Paulson playing with taxpayer money, not his own) stepped in and decreed that the bankrupt banks were somehow not bankrupt.
These banks were the big market makers -- having driven almost every competitor out of business because the banks operate with a government subsidy.
Now that the government subsidized market makers are functionally bankrupt but not bankrupt by executive decree -- price discovery has come apart.
This is why I tend to discount almost all the statistics you are showing on your blog -- they are not market statistics, but the opinions of a small number of bankrupt banks.
The price of US Treasuries is whatever SAFE and the NY Fed say they are -- they are not market prices but the opinions of two political entities.
Come on Scott, no matter how much bull Paulson/Geithner shovel at us -- we all know the listed price for many securities is **NOT** a market price at all.
Non-market orices decreed by a government central economic committee was the problem back in the 1970s -- and it is the problem today also