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.   

US Treasuries Still a Safe Haven and the Yields on TIPS Remain Negative

International investors still flock to the United States Treasury bond market to keep their funds in a “safe place”.  As a consequence of this, interest rate relationships continue to be distorted.  Since early August 2011, the yield on the 10-year US Treasury bond has fluctuated somewhere around the 2.00 percent level. 

These declines occurred during the fall events that surrounded the fiscal problems in Greece.  The yields have remained at these low levels through the Greek restructuring and into the recurring concerns over the budget fights in Spain and Italy. 

The dramatic drop in the Treasury yield can be seen in the accompanying chart.  The 10-year Treasury was trading at or above 3.00 percent up until early August 2011.  Then the drop occurred.  And, the yield has basically moved around 2.00 percent since then. 

The interesting thing to me in this shift is what has happened to the yield on US Treasury Inflation-indexed securities.  They went negative in early August and, after bouncing around for a couple of months, dropped into negative territory again in early November and have stayed there since.  This can be seen in the chart below.  Yesterday the 10-year Treasury inflation indexed bond closed to yield a negative 0.31 percent.

The Treasury inflation indexed bond, since it was created, has served as a proxy for the “real” rate of interest.  It has varied a great deal more than one would like an “expected” real rate of interest to vary, but it, nonetheless has provided a benchmark that can be useful in analyzing what is going on in financial markets. 

Theoretically, the “real” rate of interest should be equal to the long-run rate of growth of the economy.  Over the past fifty years, a “rough” workable estimate for the real rate of interest was 3.0 percent, which was close to the compound rate of growth of real GDP from 1960 to the 2000s.

One could then get a “rough” estimate of the inflationary expectations built into interest rates by subtracting this estimate of the real rate of interest from a nominal rate of interest, the yield on the 10-year US Treasury bond.  Then one could compare the yield on the Treasury inflation indexed bond with these other measures in an attempt to understand what was currently going on.

In the current situation, one hard to support any proxy estimate for the “real” rate of interest.  The old estimates derived from the real growth rate of GDP seem useless given the current environment. (http://seekingalpha.com/article/503181-economic-growth-will-continue-entering-the-next-stage)  And, the combined effects of the Federal Reserve’s quantitative easing and the “flight to quality” of the international investor have distorted market relationships.  That is, the past is not a good guide to the present interest rate relationships.

Rather than starting with an estimate of the “real” rate of interest, it seems that the place where one should begin is the nominal yield, the yield on the 10-year Treasury security.  Yesterday, the 10-year Treasury security closed with a yield of just about 2.00 percent.  The yield on the 10-year Treasury inflation indexed security closed at about a negative 0.30 percent. 

The difference between the two, about 230 basis points can be used as an estimate of the inflationary expectations of the market.  The year-over-year rate of increase in the price deflator for GDP was slightly about 210 basis points.  Thus, one could argue that the relationship between the yield on the 10-year Treasury security and the yield on the 10-year Treasury inflation indexed security…the proxy for inflationary expectations…was roughly in line with the actual inflation going on in the economy. 

One could then argue that the yield on the 10-year Treasury inflation indexed securities is negative because the flight to quality, along with the quantitative easing on the part of the Fed, has resulted in the yield of the 10-year Treasury reaching such a low level.  That is, the Fed’s actions along with the European financial crisis has distorted interest rate relationships to the point where we actually have some market interest rates that are negative.  The inflation-indexed security bears a negative yield because investors still must consider how actual inflation will impact the nominal returns they receive on their bonds.  Given the inflation that is expected by the market and given the current level of yields on “risk free” securities, the “real” yield in the market place can be no where else but in negative territory. 

Here, then, is a way to interpret the extent of the financial upheaval going on in the world.  If the yields on the Treasury’s inflation indexed bonds remain negative or extraordinarily low, then one can assume that the risk-avoidance going on in the world is still quite high.

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.