Tuesday, August 2, 2011

Record lows in TIPS yields reflect deep pessimism

Real yields on TIPS of all maturities today reached a new record low. The main cause of lower real yields is falling nominal yields, since the difference between the two (aka expected inflation) has been largely unchanged. Long-term inflation expectations remain "anchored" around 2.5%, although shorter term inflation expectations embedded in TIPS and Treasury pricing point to inflation of around 3%. The main cause of lower nominal yields, in contrast, is the market's concern that the economy is very weak and liable to slip into a double-dip recession, as reflected in the chart below.

Undoubtedly the market remains concerned that the ratings agencies may downgrade Treasury debt in spite of today's accord to raise the debt ceiling. It is more likely, however, that the market is being driven by its Keynesian instincts which say that the big cuts in spending in today's bill will weaken the economy at a time when it is already weak.

I think these concerns are overblown. To begin with, as I outlined in a post last week, there will be no spending cuts at all. The "cuts" contained in the debt accord add up to a very modest reduction in the future growth rate of government spending. If the huge pickup in government spending failed to "stimulate" the economy, then a modest reduction in the growth of spending going forward is very unlikely to kill the economy. By gradually reducing the share of the economy that is managed by the federal government over time, today's bill should result, eventually, in a modest increase in the economy's growth because the private sector will increase its control over the economy's scarce resources and that, in turn, will result in greater efficiency, productivity, and growth.

The other side to the record-low real yield story is that the market remains concerned about inflation. Inflation expectations have not declined materially even as the economy has slowed substantially this year. The record highs that gold continues to post ($1658/oz. as I write this), coupled with a dollar that is very close to its record lows, confirm that inflation fears are alive and well. Rising gold prices also reflect, I think, a market that looks at all the sound and fury that was expended on the debt negotiations, and the paltry sums that were promised to be shaved from future spending hikes, and concludes that Washington is still miles away from where it needs to be to restore fiscal sanity.

In short, the big decline in yields this past week is the sound of deflating confidence in the future, a sentiment expressed in light-hearted fashion in the cartoon below.


brodero said...

S&P Low for 2010 1022 7/02...TTM GAAP earnings 67.91....P/E 15.04 Low for ( Now) 2011 1254 8/02 TTM GAAP earnings 83.19 P/E 15.07

brodero said...

Libor-OIS today 15....high in 2010
34...Frifay before Lehman 84...

Benjamin Cole said...

I sense we are moving into a new era, one in which the old bromides and guideposts will not work.

I don't know how we can say investors expect 3 percent inflation when the Treasury can borrow money for five years at 1.28 percent.

I wonder if 20 years ago in Japan--did anyone expect two decades of deflation and weak growth? They were the most vigorous economy on Earth, at the time. Now Japan real estate and the Nikkei Dow are down 80 percent from levels of 1990.

Obviosuly tight money does not work for Japan. Fighting inflation to a standstill has not worked for Japan. The yen is up mightily, but nothing else.

Yet Bernanke-san is completely cowed by the inflation "hawks," who should be renamed the "Chicken Inflation Littles."

It may be time to migrate assets to China/Thailand/S. Korea.
We have seen from the Bank of Japan what happens when inflation-fighting becomes the national pastime--and we have seen in China the effects of a central bank that tilts towards growth.

Modern economies don't read econ texts.

William said...

I suspect that the world is looking also at the slow down in Japan's growth following the earthquake; the European Union's PIIGS debt issues and their slowing growth; and countries like China and Brazil among others raising interest rates to cool inflationary pressures which is slowing their growth.

Hopefully all these well known issues are beginning to resolve and their growth rates will quicken.

But it's Summer time and the stock market usually swoons in mid Summer waiting for all the big players to return after their long weekends and vacations. We may not know where the market is headed until October - but then it will time for mutual funds to do their biog "window dressing" prior to closing their books for their fiscal years.

Patience will be required for a few months.

McKibbinUSA said...

The ongoing economic depression along Main Street USA is unlikely to improve anytime soon -- even Federalism is finding itself mired in decline as the nation's lawmapers continue to debate austerity measures ad nauseum -- the worst of all possible worlds is appearing before us in the form of no default, no monetary expansion, and no austerity -- said another way, expect nothing significant to be done by the nation's fiscal and monetary policy-makers in the coming months -- keep your eyes on the the "invisible hand" as it now has its way our nation's future -- states such as California are in for very hard times -- ruin is now imminent for those who have not prepared -- maybe that's sll good in the long-run -- expect the price of guns to rise...

Anonymous said...

Could today's sell-off have been some sort of treasury short covering rally? With the debt ceiling issue now resolved and the A-OK given to hold treasuries again, maybe everyone was trying to buy back some treasuries they'd sold off the past few weeks, funding it by selling their stocks??

Just an idea.

I can't think of any other reason why there'd be such a big selloff. The personal income news today was a bit of a disappointment, but not worth a 266-point selloff. Auto sales went up 6% from last month.

My aforementioned Dailyjobsupdate website shows the rising trends in withholding taxes continuing apace. Maybe the ADP report tomorrow will make the markets realize, "What was I thinking?"

I just don't see any horrible news out there. Some disappointments, yes, but not impending doomsday.

Benjamin Cole said...


The market is realizing that, juts like Japan, deficit spending will not lead to growth. But, just like Japan, tight money will not lead to growth either.

BTW, money is tight if it does not stimulate growth. Money is tight if you see deflation.

Signs of deflation are a commercial real estate market with values at 2001 levels, or a S&P 500 below 1999 levels, and flat unit labor costs for the last three years. Commercial rents of all kinds are slumping.

House prices in Miami are 10 percent below year-ago levels--in short, the signs are trending towards deflation, not inflation.

We see what deflation did to Japan. Japanese-style central banking is the biggest threat to American security and prosperity today.

William said...

Unknown: Perhaps you have something there. On big "downdays" I usually wonder if some hedge fund - or funds - have gotten it badly wrong. If so, that news should come out over the next day or so.

Public Library said...

Great cartoon. Captures the idiocity succinctly.

Benjamin Cole said...

“I can live with moderate inflation if it means boom times again.”

Wisest words ever spoken.

William said...

Benjamin : Reuters, West's mid-life crisis points to power shift east

"The world's industrialized nations, burdened with aging populations and deeply in debt, face years of slow economic growth that could speed the shift of economic clout to the East."


Copy and paste into your Internet browser.

Anonymous said...

Here's someone I think Benjamin might like:

Dyseconomics: The New Macro Econ and the Greatest Economic Boom Ever

Anonymous said...

Don't know if anyone else noticed this, but the federal funds rate skyrocketed Friday and Monday.

Federal funds rate

It would be tempting to attribute that to something to do with the debt ceiling debate, but on Monday it was already announced a deal was made, so why would it still go up? Furthermore, the many days before that it was hitting rock bottom even as the debate seemed like it was going nowhere.

Something funny is definitely going on.

Anonymous said...

I also just noticed on the Fed's website it hasn't been that high since early February.

Can't help but wonder if that also had something to do with today's selloff.

Anonymous said...

I wonder if 20 years ago in Japan--did anyone expect two decades of deflation and weak growth?

Actually, real per capita GDP growth has been higher for Japan than for the US. We've grown 42%, whereas they've grown 60%. GDP growth has been higher for the US because we've admitted large numbers of immigrants, whereas Japan's population growth has flat-lined, due to birth-rates 1/2 of ours.

Benjamin Cole said...


I have seen calculations adjusting for per capita and other factors in Japan, which make things look not so bad.

But your numbers are off the boards--please provide cite.

Benjamin Cole said...


I have a question.

The interest rate on US 10-year bonds is currently 2.62%.

Yet you say investors are expecting inflation in the 2.5-3 percent range.

How can this be?

Back in the gaslamp era, when I was in college, I think I was taught investors wanted 2 percent real yield on long-term gilts.

This suggest to me investors expect inflation under 1 percent.

Scott Grannis said...

The real yield you are referring to is a long-term average. At any given point in time, actual real yields may vary considerably from their normal, or average rate. Thanks to TIPS we now what real yields are in real time; 10-yr TIPS real yields are only 0.3% right now. Very low real yields such as these are symptomatic of a very weak economy and very accommodative monetary policy, which keeps inflation expectations alive.

Benjamin Cole said...

"Very low real yields such as these are symptomatic of a very weak economy and very accommodative monetary policy, which keeps inflation expectations alive."

Yet Japan has had very low real yields for 20 years or so. Surely, you cannot contend investors in Japan have inflationary expectations.

Does anyone in America have inflationary expectations? Who?

Scott Grannis said...

Low real yields in Japan track very weak growth, but not, in the case of Japan, easy money. Inflation expectations are negative (i.e., deflation is expected), as reflected in the -30 bps spread between 5-yr JGBs and 10-yr inflation-adjusted Japanese bonds.

Anonymous said...

Ben: I have seen calculations adjusting for per capita and other factors in Japan, which make things look not so bad.

But your numbers are off the boards--please provide cite.

The growth I cited is only for the last 10 years:

Japan: http://www.indexmundi.com/g/g.aspx?c=ja&v=67

US: http://www.indexmundi.com/g/g.aspx?c=us&v=67

Scott Grannis said...

Interesting site (index mundi), but I suspect the GDP per capita figure uses nominal GDP, not real GDP, although that wouldn't make much of a difference since Japanese inflation has been zero or negative. More importantly, it measures Japanese GDP per capita in dollar terms, not yen terms. The yen rose about 20% vs the dollar over the past decade, so this is adding almost 2% per year to the growth. Still, I think it is true that Japanese real GDP per capita has been increasing at a decent rate, much more than most people suspect.

Anonymous said...

Ben: I have seen calculations adjusting for per capita and other factors in Japan, which make things look not so bad.

But your numbers are off the boards--please provide cite.

Based on the following sources, it appears that Japan and US nominal GDP per capita growth rates were 2.71% and 3.60% respectively, between 1990 and 2010:



I'd argue that we can't really compare growth rates for these periods because Japan's start point in 1990 was at a real estate bubble-induced peak, whereas our end point in 2010 was also at a real estate bubble-induced peak. I think comparable periods would be Japan from 1990-2010 and US from 2005-2025.

PS How do you compare GDP numbers if not on a per capita basis?

Anonymous said...

Interesting site (index mundi), but I suspect the GDP per capita figure uses nominal GDP, not real GDP

I'd have to agree that the numbers are not inflation-adjusted, based on an inspection of the underlying numbers (also available via pull-down menus), which appear to be generated by dividing PPP GDP by the population in the respective years. This means that the numbers tend to overstate US growth, given that inflation has been higher stateside.