Wednesday, June 17, 2009

Bonds are priced to 2% inflation

This chart is set up so that when the two lines overlap, a 30-year T-bond will pay you 2 percentage points more than core inflation, as measured by the CPI. Many would consider that to be "fair value," since over long periods that is about what the real return on long-term Treasury bonds has been. As you can easily see, however, for most of the past 20 years T-bonds have yielded much more than their fair value yield, until recently. Right now you could say that T-bonds are trading at fair value, if you believe that core inflation is going to remain around 2% forever.

If inflation rises, however, T-bonds are going to deliver miserable returns. Either their yield will remain low, lagging the rise in inflation (in which case their real yields will be less than 2% per year or even negative), or yields will rise as inflation rises and the price of the bonds will fall. In the case of the current 30-year T-bond, its price will fall about 17% for every 1 percentage point rise in yields. Just a modest rise in inflation and yields could wipe out several years of coupon payments.

Since early 1980 and up to the end of last year, T-bonds delivered excellent returns, but that was mainly because their yields were much higher that inflation, and declining. Returns were excellent because the bond market was chronically over-estimating the rate of inflation. Now the bond market is betting that inflation will remain around 2% forever. Importantly, the fears of deflation which pulled bond yields down at the end of last year have all but vanished. But the bond market is not at all prepared for an eventual rise in inflation.

Caveat emptor.

Full disclosure: I am long TBT at the time of this writing.


Anonymous said...

Ah, so you have shared in the pain the past few days as well. I'm long TMV. Ouch! I intend to hold onto it for the foreseeable future though.

2% inflation for the long term is just ridiculous.

Scott Grannis said...

I have been long TBT since early this year. This is going to be a long-term holding, unless the Fed starts taking aggressive steps to reverse its massive liquidity injections.

Anonymous said...

> I have been long TBT since early this year.


> This is going to be a long-term holding, unless the Fed starts taking aggressive steps to reverse its massive liquidity injections.

Same here. TMV is new (listed on April 16, 2009). I was tempted, but didn't get in until early June.

Public Library said...

If you would have implemented that same strategy + an equity reflation trade after the Japanese real estate bust you would have gone bust yourself.

What are the risks if we have only just begun the deleveraging pricess?

Public Library said...


Scott Grannis said...

Public: There is one major, huge difference between Japan's deflation and our current situation: the Fed has been actively engaged in a very aggressive quantitative easing since last September, while the Bank of Japan allowed a massive monetary contraction in 1992 and only began a quantitative easing program in late 2001. Monetary policy, especially when practiced with great vigor, can have powerful results. Best advice: never underestimate the Fed's ability to get what it wants. In this case the Fed does NOT want deflation and would be happy to see housing prices hold steady or rise.

Mark A. Sadowski said...

If the bond market has consistently overestimated the rate of inflation for the past 30 years or so why should now be any different?

And with respect to Japan, while they were much slower off the dime than us with monetary expansion they still nearly tripled their monetary base between 1994 and 2006. Nevertheless their GDP deflator has dropped year after year and real estate prices have now fallen for 18 years straight.

I think Public has a right to be sceptical. And no, the Fed doesn't get everything it wants.

P.S. Core PPI dropped last month for the first time.

alstry said...

At what point do the Chinese and Russians tell us to shove our dollars up our backside and it costs us a boatload of dollars for one Chinese doll as interest skyrocket to 20%???

How long do you think the world is going to idly sit back and watch Uncle Benny piss away the value of their dollar demoninated assets simply to maintain our welfare state????

You know, most of them have guns too!!!!

Public Library said...

I agree you cannot fight the Fed, however I am starting to wonder if the Fed can fight the Globe.

Scott Grannis said...

Mark: I should have added that the bond market consistently underestimated inflation all throughout the 1970s. Bonds don't always get it right, and neither does the Fed.

Scott Grannis said...

alstry: The Fed hasn't yet destroyed the value of the dollar. The dollar is down against gold, but so is every other currency. Commodities are up, but they are still lower than they were a year ago. The Chinese have so many dollars that they don't want us to fail.

This can't go on forever, to be sure, but the Fed is not going to be super-accommodative forever either.

alstry said...

The Chinese have so many dollars that they don't want us to fail.

They don't have that many....and are reducing as fast as they can!!!

With the new buy China policy...all you have to do is loan each Chinese family $1000 and you no longer need America!!!

Niether does our banking system!!!! especially if we also loan each Indian family $1000 as well.

Scott Grannis said...

I don't know what you are talking about. China holds more central bank reserves (over $1 trillion) than any other central bank, and the majority of those reserves are in dollars.