Wednesday, December 14, 2011

Bond yields are out of whack




The bond market is out of whack, because bond yields are not consistent with the inflation expectations embedded in bond prices.

The top chart compares yields on 10-yr Treasuries to the year over year changes in the Core CPI. Normally, the two should move at least in the same direction, and at approximately the same level, since over time the rate of inflation is the major determinant of bond yields. Instead, they have moved sharply in opposite directions over the past 6 months or so. Ok, you say, but maybe the decline in bond yields is simply the market saying that inflation will be much lower in the years to come?

If that were the case, then the second chart would look very different. As it is, it plots the market's 5-yr, 5-yr forward expected annual rate of inflation, based on the relative prices of 5- and 10-yr TIPS and Treasuries. This is the sensitive, forward-looking measure of inflation expectations that the Fed considers to be the most important and most reliable. Inflation expectations by this measure are about where they've been for the past 10 years (between 2 and 2.5%), so there's nothing unusual here. And if you consider the third chart, which compares 10-yr Treasuries to 10-yr TIPS, the message is the same: inflation expectations are nothing out of the ordinary, and very much in line with what we have seen over the past decade.

So the problem is that the current level of 10-yr bond yields is priced as if inflation were headed to zero, when a broader look at the TIPS and Treasury market reveals that inflation expectations are somewhere in the neighborhood of 2-2.5%.

The only reasonable explanation for this divergence, as far as I can tell, is that the level of Treasury yields is artificially depressed. TIPS and Treasuries of similar maturities, when taken together, are priced to normal inflation expectations, but in isolation their yields are too low to be consistent with their implied inflation expectations.

This is a highly unusual circumstance that can only have highly unusual roots. I think those roots are most likely to be found in the Eurozone. Such is the fear that the PIIGS defaults will destroy the Eurozone banking system and ultimately lead to a global depression and a financial market collapse, that investors are willing to pay exorbitant prices for Treasuries in view of their safe-haven status. The risk-free status of Treasuries seems paramount, far more important than possible concerns about inflation.

If there is a message here for investors, it's that fear has reached extraordinary levels, artificially inflating the prices of Treasuries. And it's not a stretch to go from that conclusion to the belief that fear is also artificially depressing the prices of equities.

Current prices can hold only if we really are on the cusp of a major collapse. To be bearish you have to believe that the collapse will be unlike anything we have ever seen before, or maybe even worse.

13 comments:

William said...

Scott Grannis wrote:
"The only reasonable explanation for this divergence, as far as I can tell, is that the level of Treasury yields is artificially depressed."

Are corporate bonds, hi-yield corporate bonds and municipal bonds priced to reflect 2 - 2.5% long term inflation? Or are they also artificially "out of wack"?

John said...

From SG:
"Instead of "stimulating" the economy, enormous increases—in both nominal and relative terms—in federal spending have ended up "stimulating" the unemployment rate more than anything else. The reason? The public sector spends money much less efficiently than the private sector."

Given the "inefficient" ways government spends money, why are Treasuries a "safe haven?"

Wouldn't corporate bonds, issued by the "more efficient" private sector be the better bet?

This is not a rhetorical question. Why aren't corporate bonds in greater demand?

Benjamin said...

Somehow, I just can't get riled up about a 2 percent core inflation rate, a rate that now appears to be waning.

Evidently, bond investors don't worry about it either. They anticipate even lower inflation. Perhaps they see another deflationary recession in the wings--Europe looks that way. Maybe they think the USA is the next Japan. Maybe we are.

From 1982 to 2007, USA industrial production doubled, while inflation ran from 2 percent to 6 percent. The historical record shows we flourished with mild and varying inflation. That is the fact--not a theory, not a ideological position.

The current peevish fixation on inflation is misplaced and self-destructive.

Let's go back to fixating on food and sex. At least we get something back from that sort of obsession.

Scott Grannis said...

Re: corporate bonds. I think that artificially depressed Treasury yields are contributing to the recent widening of corporate spreads, making them look riskier than they probably are. However, yields on corporate bonds are historically low, suggesting that investors do find them somewhat attractive. In any event, corporate bonds are typically priced relative to Treasuries, not to inflation. I have argued for a long time that corporate bonds are far more attractive than Treasuries, and that remains the case.

Ed R said...

" . . . .artificially depressed Treasury yields"

How can the price of anything that has massive trading in open markets have an 'artificial' price?

If you think the yields are 'artificially' depressed then they must be due for a 'correction'.

So why don't you call your broker and sell short some USG bonds? If current yields are truly artificially depressed, the bonds are certain to soon decline in value with a big payoff to you.

Go ahead and prove you are right.

It is only money.

Dr William J McKibbin said...

Another explanation is that the markets are pricing for deflation and depression, which is increasingly evident across Main Street USA, and even the national economy, as evidenced by the sharp downward trend in the employment to population ratio, the extended declines in home prices, and the extended decline in wage-earners' real wages over the past decade -- all of this evidence indicates that the markets are now preparing for deflation and depression...

John said...

Ed R makes a point like an ice pick in the forhead.

I think Treasuries are a safe haven because the USG has a massive armed forces to protect it from hostile takover and it can print its own currency. Plus, if not mistaken, it has always made good on its bonds. Correct?

Dr William J McKibbin said...

Perhaps global investors are turning to bonds as a safe haven from deflation -- afterall, near zero interest is certainly not the incentive to hold treasuries -- we need to keep an eye on all explanations, including the notion of a market that is preparing for global depression...

Ed R said...

The CDS on USG debt is the lowest of ANY significant country. (yes, Norway -- with a large BoP surplus and its own currency -- is slightly lower).

CDS on USG debt are lower than most of the other AAA-rated countries; Germany, France, Netherlands etc. And this despite the GOP's efforts to sabatoge the credit rating of the USA in August.

What is it that free and open markets know that S&P, Scott Grannis, Alan Simpson, David Walker, Eric Cantor and the Bond Vigilantes don't know??

Donny Baseball said...

The CDS market and the Bond Vigilantes know that the US is always the last safe house. That doesn't mean the house is necessarily safe, just more attractive relatively. If it looks like 1) Europe can solve its problems through self-imposed fiscal rectitude, and 2) the US is looking at 4 more years of $1.3T deficits, then CDS will widen and the BMVs will show up right quick.

Ed R said...

" - - - the US is looking at 4 more years of $1.3T deficits, then CDS will widen and the BMVs will show up right quick."

The BMV's, the everyone-must-suffer wing of the GOP, the sky-is-falling group (led by David Walker, Ron Paul and Alan Simpson), etc. have been telling us this for at least a couple of years. Yet interest rates on USG debt have, once again, hit new RECORD LOWS this week; and CDS have gone even lower.


BTW; what are the chances of the Europeans curing their problems "through self-imposed fiscal rectitude"?? How are they doing so far??

Benjamin said...

The Euroone is cooked, from what I can tell.

Despite the fact that no modern economy has flourished with inflation rates below 2 percent, German is seeking to impost such a peevish regimen on the entire continent.

Ergo, there wil have bankrupt nations.

The belief in ultra-tight money is faith-based---a half-baked ideology or religion, usually tied to some sort of genuflection to gold.

From 1982 to 2007, USA industrial production doubled, while inflation ran from 2 percent to 6 percent. The historical record shows we flourished with mild and varying inflation. That is the fact--not a theory, not a ideological position or a partisan shibboleth.

Yet we have inflation-hating zealots speaking of the idealistic utopia that exists if we suffocate the economy enough to eliminate inflation.

Japan shows us what happens to a nation under tight money. It is in perpetual decline.

Donny Baseball said...

In re Europe, the Irish seem to be healing slowly through a combo of fiscal restraint and standing by their pro-growth tax regime. The Spaniards actually voted to take their medicine in the form of Rajoy. The Italians were given no choice and will be less successful but at least monti owes his power to no one in italy so he is not bound by the decades of bribes that his predecessors made to get elected. Greece and Portugal remain basketcases, but small ones. The ECB is doing something that looks very close to the Fed's "quantitative easing" but without explicitly saying so. This keeps fiscal authorities nervous and incented to rein in spending (unlike here where congress knows the Fed will print print print). I'm not saying Europe is just fine, just saying there is a chance they pull the aircraft out of the nosedive.

The flaw in your argument is that low interest rates mean there is no fiscal danger. The bond market doesn't work like that. Rates are artificially low and have been manipulated lower for years now while the fiscal pressures have been building. When the sentiment turns, it will turn fast.