Monday, April 5, 2010
I've argued for awhile now that higher yields on Treasury bonds would not pose a threat to growth or to the stock market, since they would be a signal that the economic outlook was improving. This chart proves my point. 10-yr Treasury yields have increased about 80 bps since the end of last November, and real yields on 10-yr TIPS have increased by almost as much (67 bps). The difference between the two yields is the market's expectation for the average rate of consumer price inflation over the next 10 years (the breakeven inflation rate). Inflation expectations have increased only 13 bps in the past four months or so, even as yields have surged, which means that the rise in yields has been driven primarily by increased growth expectations.
This pattern—rising Treasury yields being matched closely by rising TIPS yields—could continue awhile longer. But before too long I would expect Treasury yields to rise much more than TIPS yields—and TIP yields to stop rising and begin falling, even as Treasury yields rise—as the market begins to realize that stronger and stronger growth brings with it more inflation risk. If nothing else, it should make you nervous today that the economic outlook is brightening but the Fed remains stuck on zero. As today's WSJ points out, Fed governors can't agree on whether inflation risks are rising or falling, so in the meantime they are doing nothing to reverse their quantitative easing. That makes it much more likely that they will fall behind the inflation curve as the economy picks up.
As this chart (above) shows, TIPS have gone from being quite expensive at the end of last November (1.1% real yields), to now being fairly valued according to my estimates. I doubt they will rise much above 2%, since at that point they would be getting increasingly attractive at a time when inflation fears would begin setting in; increased demand for TIPS would tend to push their prices up and their real yields down.
Full disclosure: I am long TIPS and TIP as of this writing, and short Treasury yields by virtue of having a 30-yr fixed mortgage.
Posted by Scott Grannis at 9:37 AM