Sometimes it’s best to let the numbers do the talking. Without further adieu, we offer the following statistical recap on the 10-year Treasury yield, its counterpart in the 10-year real yield a.k.a. TIPS, and the spread between the two.
As always, minds will differ as to the implications of the above chart, and so what follows is your editor’s view, which may or may not be relevant for the foreseeable future. That caveat aside, consider the persistent decline in 10-year yields in both nominal and real measures since last July. On this point, at least, all can agree: the bond market’s become increasingly giddy, bidding up the price of government debt, which, of course, results in pushing yields down.
The 10-year Treasury’s nominal yield was comfortably north of 5.0% midway in 2007; at last night’s close it was 3.68%.
For the 10-year TIPS, a similar story has been unfolding, albeit at lower rates, which is typical for real relative to nominal. Back in June 2007, the 10-year TIPS yield was as high as 2.83% at one point; now it’s 1.44%.
Meanwhile, consider the spread between yields on nominal Treasuries and TIPs, a gap that’s considered a measure (albeit not the only one or necessarily an infallible one) of Mr. Market’s inflation outlook. As such, the two Treasury markets are priced in anticipation of inflation of 2.24%, defined as the current 10-year yield (3.68%) less the current 10-year TIPS yield (1.44%). Oh, and by the way, the spread has remained fairly constant for the past six months or so, as the chart above reminds. The implication: the inflation outlook hasn’t change much, if at all since last summer.
Ah, but here’s where it gets interesting, or frightening, depending on your perspective. The latest Consumer Price Index numbers, which are widely accepted (tolerated?) as the U.S. inflation rate reveals prices rising by 4.1% for 2007. That’s far above the 2.24% inflation rate implied by the spread in nominal and real Treasury yields.
Adding to worries is the fact that the core rate of CPI inflation, which the Fed says is a more useful measure of divining future pricing trends, is running at 2.4%. Lower, but still above the 2.24% forecast drawn from the spread in Treasuries.
To be fair, there’s no shortage of dismal scientists who think inflation will behave in the months and years ahead. It goes without saying that many if not most bond investors agree, or so the associated plunge in yields suggest.
But it’s only fair to point out that the dissenters are growing in number, starting with the gold market, which just happened to run prices of the precious metal up to an all-time closing high yesterday at just under $913 an ounce. Adding to the inflation fears is the fact that the dollar remains weak, hovering just above record lows, as measured by the U.S. Dollar Index. Of course, a weaker dollar whips up the winds of import inflation, starting with the massive and growing quantities of oil shipped in to the U.S. from foreign suppliers. And then there’s the Fed’s massive 75-basis-point rate cut on Tuesday and expectations that more easing is coming when the FOMC meets next week. Call us crazy, but maybe just maybe inflation may be at risk of ticking up a notch or two down the road.
You don’t have to expect inflation to surge skyward to think that lightening up on bonds seems reasonable. For our money, we’re more convinced than ever that bonds, at best, offer limited value. Yes, economic apocalypse may be coming, in which case bonds may deliver another run of robust returns. But what if the recession (if in fact one’s coming) is relatively mild and brief, as has been the trend for the past 20 years? If so, one shouldn’t expect pricing power to evaporate for 2009 and beyond.
In any case, there’s no getting around the fact that Treasuries are priced for something approximating perfection in future inflation. If you think that’s likely, you’re part of the majority, and there’s always room for one more in the crowd.