Friday, April 13, 2012

Reading the Treasury tea leaves

The purpose of these two charts is to show that the bond market is not always right when it comes to inflation. From a long-term perspective (e.g., 50 years), the yield on risk-free Treasuries of 10 years' maturity or more has averaged about 2.5 percentage points above inflation. This is rational, because while Treasuries are default-free, tying one's money up for a multi-year period puts the investor at risk of receiving a return that fails to maintain the purchasing power of his funds. So moving out the Treasury yield curve should give an investor some modest expected real return, and 2.5% sounds about right. But over shorter time frames, it doesn't always work this way.

The top chart compares the yield on 30-yr Treasuries to the Core CPI, and the bottom chart compares the same yield to the PCE deflator, which is a broader and somewhat more volatile measure of inflation than is the core CPI. Both charts are set up to show that when yields and inflation converge, that is equivalent to a 2.5 percentage point expected real rate of return. In other words, when the two lines are on top of each other, bonds are arguably fairly valued.

But bonds are not always fairly valued, as should be obvious. Bond yields were way below where they should have been in the 1970s, mainly because investors were slow to raise their expectations for inflation as actual inflation exceeded expectations. By the early 1980s, however, everyone knew inflation was a big problem and so the yield on long bonds rose to levels that exceeded inflation by a substantial margin. (I was lucky enough to realize this at the time, and bought 30-year Treasury strips yielding over 11% for my IRA account which I sold 10 years later for a 300% profit.) Then, as inflation gradually subsided over the course of the 80s and 90s, bond yields slowly declined as well, until they reached something close to fair value by the early 2000s. Since then—a period that began around the time when the Fed started easing in earnest in 2002—bond yields have been at or below fair value more often than not, and especially in the past year. Over the course of the past year, inflation has settled in around 2-2.5%, but long bond yields have dipped to 3%, and 10-yr Treasury yields today are only 2%.

Buying Treasury bonds at today's yields is not a very attractive proposition, since recent inflation and inflation expectations are higher than most of the Treasury yield curve. For example, the CPI has averaged 2.7% per year for the past two years; the 5-yr, 5-yr forward inflation expectation embedded in the Treasury yield curve is 2.6% today, and has averaged 2.6% over the past year; and the 10-yr expected inflation rate embedded in TIPS is 2.3%. So if inflation comes in around expectations, buying the long bond today at 3.15% gives you an expected real return of just over 0.5% per year, whereas buying the 10-yr Treasury today gives you a negative expected real return.

With Treasury yields this low relative to inflation, it only seems reasonable to conclude that the market is willing to pay a premium for the safety of Treasuries, and that premium in turn is motivated by deep concerns over the economy's ability to grow. Investors are content to accept the likelihood of a negative real rate of return in exchange for protection against default, and paying a premium for protection against default only makes sense if you are really concerned that a weak economy is going to significantly increase the risk of defaults.

This is why I see today's Treasury yields as a very good indicator that the market is still dominated by fear, rather than by optimism. I think the economy is very unlikely to deteriorate significantly, but neither do I see it being very strong. But since the market is dominated by fears of weakness, my view makes me effectively an optimist.


Public Library said...

IMF out with an article talking about reduction is "safe" assets. This in turn can/will drive up the price of the remaining safe assets until it forces people out onto the risk spectrum.

There are a lot of unintentional consequences mucking around in the Global economy courteous of central banks.

Benjamin Cole said...

Nice charts. I suppose one can pick a year in the past to make a point.

In the last fours years, we are tracking inflation, as measured by the CPI, at under 2 percent. Many right-wingers say the CPI overstates inflation, as does Don Boudreaux of George Mason University.

The CPI index for Feb 2012 is 229.4 and four years earlier was 213.5. That is less than two percent inflation a year.

The TIPS market is expecting less than 2 percent inflation going forward.

Markets can be wrong---high or low.

If Japan is our future, then we are overpaying Treasury bond holders now. Like Scott Grannis, they will be happy they bought bonds when yields decline further, or we stumble along in deflation.

If we have higher inflation, bondholders may be sorry they were not in property or equities. They are not sacrosanct; they are making bets on the market like all other investors.

Right now, we are following a Japan policy of big federal budget deficits and tight money. If you think interest rates suggest we have loose money think again--Japan has been at zero for a long time. They have had 15 percent deflation in last 20 years.

I can't call this one. I sense economic fundamentals are shifting, and the old shibboleths and bromides are getting more encrusted and inaccurate every day.

Like Japan we may be fighting the wrong economic battles.

Lll Len said...

I would have thought today's treasury yields are dominated by the Federal Reserves actions rather than by fear or optimism.