In a post back in October 2012, I noted "The unattractiveness of Treasuries," citing the fact that Treasury yields were very low relative to core inflation. I rejected the hypothesis—which was then quite common—that the depressed level of Treasury yields was due to the Fed's QE purchases, noting that the Fed's purchases were only a small fraction of the outstanding value of Treasuries, and arguing instead that Treasury yields are set by the market's demand to hold the entire outstanding stock of Treasuries, which in turn is a function of the market's expectations for future growth and inflation. The very low level of Treasury yields back then was, I thought, primarily due to the market's pessimistic outlook for U.S. growth. In hindsight, with Treasury yields up substantially since then, even though the Fed has purchased tons of Treasuries in the interim, I think the facts have born out my hypothesis.
As the chart above shows, the huge gap between 30-yr Treasury yields and core inflation which opened up in the 2011-2012 period has now almost completely closed, with rising yields doing the lion's share of the closing. If yields were low back then because the market was very worried about the prospects for U.S. growth, it is certainly less worried today.
The above chart looks at the same relationship from a slightly different perspective, using 10-yr yields instead of 30-yr yields, shortening the time frame to only four years instead of several decades, and using forward-looking inflation expectations instead of actual inflation. However, the story is the same. Yields today are much better aligned with inflation fundamentals than they were in late 2012.
So what has caused Treasury yields to move sharply higher? Many would undoubtedly argue that the bond market is reacting to the prospect of 1) the tapering of QE and 2) the eventual reversal of QE. That would be hard to refute, since yields jumped last Spring when the notion of "tapering" was first floated. But as I argued last May:
... the Fed can only influence yields to the extent that the market's view of the economy is similar to the Fed's. If both expect the economy to be very weak, yields will be low, and prices will behave as if Fed purchases of bonds to stimulate the economy are in fact achieving their stated objective (i.e., QE purchases depress yields). But if the market thinks the economy is improving and/or inflation is rising, then no amount of Fed purchases will be able to keep yields from rising.Even though the Fed continued to buy boatloads of bonds throughout last year, and even though the Fed didn't begin to taper its purchases until very recently, yields rose sharply and continue to be significantly higher than they were when QE3 began in late 2012. I believe that is because both the bond market and the Fed have revised upwards their assessment of the health of the U.S. economy, and with an improving growth outlook. Better growth expectations can be seen in the chart below, which compares the real yield on 5-yr TIPS to the prevailing rate of growth of the economy.
Whether expectations for growth are now optimistic or merely moderate is the key question. I believe that the above chart tells the story: the market is still priced to expectations of weak growth. Yields would likely move up another 100-200 basis points if the market (and the Fed) became convinced that economic growth would be at least 3% going forward. In short, the bond market is not yet optimistic about growth, but it is definitely less pessimistic than it was last Spring.
From this it follows that equities today are more reasonably priced, but with less upside potential than before—but still attractive.