What Are the Bond Markets Trying to Tell Us?

What are investors in the bond markets trying to tell us?  To me, we must give some kind of interpretation to where current yields are in order to get some idea about where financial markets believe that the economy is going.

Historically, one could take an estimate for the expected real rate of interest and add to this one’s expectation for inflation and come up with a projection for what the nominal rate of interest on United States Treasury should be. 

In today’s environment this is problematic.  In the past a good proxy for the expected real rate of interest was the expected long-term growth rate of the economy. (Equating the expected real rate of interest with the expected long-term growth rate of the economy has the backing of the accepted economic growth theory and has worked on a practical basis.)

Whereas in the past one could estimate the expected real rate of interest at around 3.00 percent since the expected long-run rate of growth of the economy could be around this number. 

Being a little more conservative let’s say that the expected real rate of growth of the economy in the near term will be around 2.25 percent. (http://seekingalpha.com/article/503181-economic-growth-will-continue-entering-the-next-stage) Given the rule presented above this means that we could expect that the real rate of interest in the economy should be around 2.25 percent.

Now, the current year-over-year rate of increase in the GDP implicit price deflator is 2.1 percent.  Again, to be conservative, let’s assume that our expected rate of inflation is just 2.0 percent.

This would mean that our estimate for the yield on the 10-year US Treasury bond would be 4.25 percent even given our very conservative estimates of the real rate of interest and inflationary expectations. 

This forecast is problematic because the current yield on the 10-year US Treasury bond is around 2.00 percent. 

 The problem that we are dealing with at the present time is that the United States is experiencing an inflow of funds from the rest of the world due to a “flight to quality” coming from the continent of Europe.  In this “flight to quality” investors are not looking at earning a sufficient amount of return to earn themselves an inflation protected real rate of interest.  These investors are looking primarily for a “safe haven” in which to place their funds and earn something more than they would earn keeping their funds in cash or very short-term securities. (http://seekingalpha.com/article/507891-u-s-treasuries-still-a-safe-haven-and-yields-on-tips-remain-negative)

 

This “flight-to-quality” has driven the yield on the 10-year US Treasury security to around 2.00 percent.  This “flight” is the dominating force in the bond market these days.

This “flight” is even dominating whatever the Federal Reserve is doing these days.  The interpretation here is that the supply of funds coming into the US market is keeping these interest rates so low allowing the Fed to do next to nothing in keeping US interest rates so low.  (http://seekingalpha.com/article/519961-don-t-expect-qe3-from-the-fed-this-week) This, of course, is taking some of the pressure off Fed Chairman Ben Bernanke. (http://seekingalpha.com/article/542361-economic-growth-for-the-first-quarter-good-scenario-for-bernanke)

Bond holders, however, want to be protected from the deterioration of the real value of their bonds so they are still asking for protection against the inflation they expect to face in the future.  That is why the yield on 10-year inflation-protected Treasury issues (TIPS) have been paying a negative yield.  This negative yield is around 0.30 percent. 

Thus, if one subtracts the yield on TIPS from the yield on the 10-year issue from the yield on the 10-year Treasury bond, one comes up with the market’s current estimate for future inflation.  At this time expected inflation is around 2.30 percent, a little above the current rate of inflation cited above. 

Note that the yield on TIPS became negative in early August 2011, when the European sovereign debt crisis picked up once again specifically relating to the events in Greece.  The concerns over Europe continue with the emphasis now shifted to Spain.       

In terms of the future, I would argue that the negative yield on TIPS bonds will not become positive again until the European situations eases enough so that funds will start returning to “riskier” debt in Spain, and Portugal, and Greece, and Italy.  As these funds begin to flow out of the US Treasury market, yields will begin to rise and historical relationships will return. 

What I am saying here is that if TIPS rise to around 1.00 percent, the level of earlier 2011 as seen in the accompanying chart, and inflationary expectations remain at even 2.00 percent, the yield on the 10-year Treasury issue should rise to at least 3.00 percent. 

If the economy continues to grow at a rate in excess of 2.00 percent and inflationary expectations remain at the 2.00 percent level, the yield on the 10-year Treasury issue should rise to at least 4.00 percent.

The European debt crisis is having a major impact on US bond markets and yield relationships and will continue to do so until European officials really resolve their fiscal problems.  Thus, look for what happens to the yield on TIPS in the near future.  That will provide information on what the financial markets think about European prospects.

Given this scenario, the next pressure point for the Federal Reserve will occur when the Europeans do resolve their financial issues.  Then the Federal Reserve will be faced with having to deal with rising interest rates and this will make its life just that much harder.   

TIPS Auction Still Negative

The TIPS auction that took place yesterday continued to place inflation-protected yields in negative territory.  The yield on the issue was -0.089 percent and the ten-year yield closed to yield -0.111 percent. (http://www.ft.com/intl/cms/s/0/ba90c7f2-7443-11e1-9e4d-00144feab49a.html#axzz1pwQWCSw3)

The negative yield on these inflation-protected securities does not mean that investors will not make any money on their holdings because the principal of these securities will increase if inflation rises. 

The yields of the TIPS are negative because the yields on the US Treasury yield curve are so low.  And, the yields along the yield curve are so low because of the amount of money that has flowed into this market through a “flight to quality” arising from the debt problems faced by Greece and other eurozone countries. (http://seekingalpha.com/article/446881-treasury-bond-yields-will-continue-upward-climb)

The 10-year US Treasury bond closed to yield 2.28 percent yesterday.  If one takes the difference between this bond yield and the yield on the 10-year TIPS issue as an estimate of inflationary expectations, then one can state that investors are expecting that inflation will average about 2.4 percent over the next ten years in the United States.

That is, if 10-year bonds are yielding around 2.30 percent in the market and the inflationary expectations of investors are approximately 2.40 percent, then the TIPS yield must be around

-0.10 percent to fully incorporate the possible effect of inflation on the real value of the bonds.

In the latter part of January 2012, when the last auction of TIPS came to market, 10-year US Treasury bond yield was around 2.00 percent and the yield on the 10-year TIPS issue was around -0.15.  The relationship between the two yields implied that investors expected inflation to average around 2.15 percent over the next ten years.

At the end of December 2011, inflationary expectations were around 2.00 percent, calculated in the same way.

The most important conclusion that can be drawn from this is that, in the financial markets, investors are now building more inflationary expectations into their future projections than they were several months ago. 

The actual rate of consumer price inflation, year-over-year, was 2.9 percent. (Note that this rate of increase is down from a near-term peak of 3.9 percent in September 2011.)

Inflationary expectations, as reflected in the bond markets, tend to lag behind actual inflation.

The auction yesterday reflected strong investor interest as Wall Street dealers, who underwrite the Treasury auctions, were left with only 39 percent of the offering, which was down from the 50 percent they received in January’s auction.  Also, this was the second lowest share of the 10-year TIPS auction for dealers since the market began in 1997.   

If one is looking for some evidence of when the bear market for US Treasury securities might begin, then this, I believe, is a good place to start.     

As I have argued earlier, the yield on the 10-year US Treasury security is currently as low as it is because the United States Treasury market still has a lot of funds that are there for “safety” reasons.  My belief is that this yield should be above 3.00 percent if the “flight to quality” money was not in the market. 

Thus, the yields on US Treasury securities, in my mind, need to rise just in order to get back to a range that is more consistent with where the United States is in the economic cycle. 

But, the next concern of the investors seems to be about a coming “bear” market in bonds.  This “bear” market is to come once the economy begins to grow faster…more than the 2.0 percent to 2.5 percent rate of growth now being experienced…and when all the money the Federal Reserve has pumped into the banking system starts to really impact prices in the economy. 

 My suggestion is to watch the spread between the yield between the 10-year Treasury bond and the yield on the 10-years TIPS issue. 

As real economic growth begins to pick up, the TIPS yield will have to increase to reflect the growth of the real economy.  This yield will not be determined the way it has been determined in the recent past.

And, if the real yield on the TIPS issues rise the yield on the 10-year Treasury bond must rise as the investor’s inflationary expectations get added onto the yield they are getting on the TIPS.  If the real yield on the TIPS issues rise to, say, 1.50 percent and investors expect inflation to be in the 2.5 percent range, the 10-year bond should yield at least 4.00 percent. 

As expectations of the real rate of return rise and inflationary expectations rise, the yield on 10-year bonds should be off to the races.  Then one can say that the bear market had arrived.    

Treasury Bond Yields Will Continue to Rise

Treasury bond yields are on the rise and will continue to do so over the next year. 

In my opinion, the Federal Reserve System has been given more credit than it is due concerning how low long-term Treasury securities had fallen in the past year or so.

The research I have seen during my professional career has shown that the Federal Reserve, from time-to-time, has attempted to influence the yield on long-term Treasury issues but has never been very successful, either in terms of the its ability to lower long-term yields by much or in terms of keeping them lower for an extended period of time.

This is not true, however, of short-term yields. 

I continue to believe this.

The yield on the 10-year Treasury security has been extremely low for several months now.  Around the end of July 2011, the yield on the 10-year was about 3.00 percent.  It dropped precipitously after that time, falling around 2.10 percent by August 18 and then falling below 2.00 percent the second week of September.

Since then, this yield has fluctuated between approximately 1.80 percent and 2.10 percent until last week (except for a three day bump up right at the end of October).

The most interesting move during this time period, however, has been the move into negative territory of the 10-year TIPS bond.  At the end of July 2011 the 10-year TIPS was trading around a 0.50 percent yield (which was already low historically).  On August 10 the yield had become negative, trading around a -0.155 percent yield.  That is, we had a negative real rate of interest. 

For a good portion of the time since then the yield on the 10-year TIPS has been negative.  Yesterday, this issue closed at -0.056 percent yield.

The reading on this behavior?  The movement into Treasury securities this summer was a “flight to quality” and was not a result of the actions of the Federal Reserve System. 

The Federal Reserve cannot force interest rates…long-term or short-term…below a zero interest rate.  The Fed has been very successful in keeping its target rate of interest, the Federal Funds rate near zero, but admits it cannot force this rate below zero. 

Why would investors invest in something that had a below-zero interest rate on it?  The basic reason is that these investors wanted to invest in Treasury securities…regardless of the yield.  This represented a “flight to quality” and the movement of funds affected the yields on all long-term Treasury securities.

One should note that with all the liquidity available to the financial markets, the spread between US Treasury issues and Aaa Corporate bonds rose during this time.  You do not find this type of behavior taking place except in times when there is a flight to quality.

One should also note that there was also a “flight” to German sovereign debt at this time as the yield on the 10-year German government issue fell, although not by as much as did the yield on the US Treasury issues.

The movement in Treasury yields last week was a movement back into riskier assets.  This is confirmed in a New York Times release this morning concerning the actions of hedge funds. (See “Hedge Funds Ditch Treasuries in Droves: Report”, http://www.nytimes.com/reuters/2012/03/19/business/19reuters-hedgefunds-treasuries.html?src=busln&nl=business&emc=dlbka32_20120320)

“A good deal of the recent flight from U.S. Treasuries has been driven by hedge fund selling…

Last week was the biggest weekly decline for U.S. Treasury prices since last summer. The big sell-off in government debt pushed yields to their highest levels in more than four months.

It was a sign investors see less need to put money in Treasuries for safekeeping now fears of a messy Greek debt default are fading and the U.S. jobs picture looks brighter.”

This, to me, makes much more sense than does the argument that this movement is the beginning of the bear market in bonds. (See “Bond Bear Market is Growling but Yet to Roar,” http://professional.wsj.com/article/SB10001424052702303812904577291770173587542.html?mod=ITP_moneyandinvesting_6&mg=reno-secaucus-wsj)

Also, as the yield on 10-year Treasury securities rose last week the yield on 10-year German bonds rose as well.

Long-term yields will begin to rise at some time in the future but I don’t believe that we have reached that stage of the cycle at this time.  The bond market still needs to re-position itself to risk-based assets and reduce its need for a “safe haven.”  This will continue, I believe, for the short-term. 

I think that the yield on the 10-year Treasury needs to return to above 3.00 percent and the yield on the 10-year TIPS bond needs to get back up into the 0.50 percent to 1.00 percent range.  This will restore some of the relative yield spreads to levels that are more consistent with current economic conditions. 

These yields will begin to rise along with economic growth as the economy picks up steam.  However, I don’t see that there will be much “steam” in the next three or four quarters. (http://seekingalpha.com/article/437481-economic-recovery-the-good-and-the-bad) 

Furthermore, the Federal Reserve will continue to err on the side of ease until the economic recovery does appear to accelerate.  Although Fed ease will not hold down long-term interest rates once they begin to climb on any experienced economic pickup, the Fed wants to avoid disruptive bank failures or other surprises that might occur on the path to recovery.

Of course, we could always have another situation in which a further “flight to quality” would cause long-term Treasury yields to drop.  Greece is not out-of-the-woods yet, and there is still Ireland, Portugal, Spain, and Italy to deal with.