It’s a simple calculation, although the implications may be huge.
Adjusting the 10-year Treasury yield by consumer price inflation tells us what we already know: money is loose, and by design. The Federal Reserve has been intentionally pumping liquidity into the economy to cure the various ills that hound the American business machine. But with the real (inflation adjusted) 10-year yield plumbing depths rarely seen, it’s time to ask (again) what it all means.
As the chart above illustrates, the CPI-adjusted 10-year yield dropped to -0.8% in June. That’s the lowest negative real yield for the benchmark Treasury since 1980. Using last night’s closing 4.09% yield and June’s 4.9% 12-month CPI change, we remain at roughly -0.8%.
What does it imply? That depends on your expectations. It could mean that we’re giving inflation the fuel it needs to take deeper root in coming years. Or, it mean be just the ticket to temper the economic contraction that’s set to get worse.
No one really knows which scenario is coming. Rather than attempt the impossible, let’s review how we’re calculating real Treasury yields to gain a bit of perspective of where we’ve been and where we may be going.
For the chart above, we begin with the monthly average for the constant maturity for the 10-year Treasury, as per the St. Louis Fed. We then adjust that monthly number by the comparable 12-month trailing change in CPI, as reported by the Bureau of Labor Statistics.
Yes, there are other ways to calculate real yields, including looking at the TIPS market, or using the personal consumption expenditures inflation rate. And while we can get somewhat different estimates of real yields by looking at various data series, the basic trend is the same: real yields are falling. Depending on the numbers crunched, the real yield may be in generational low territory, as it is in the calculation used in our chart above.
Perhaps, then, the primary question in the search for real yields is whether we should use headline or core inflation? Here’s where number selection makes a huge difference in results. For example, if we adjust the 10-year yield by the 12-month change in core CPI, the real 10-year yield is 1.7% as of June. That’s a bit low relative to recent history, although it’s hardly abnormal. It’s also a world above the -0.8% we get when using headline inflation.
The subject of whether headline or core inflation is a better measure of inflation is a contentious one these days, as we’ve discussed many times over the years, including here and here. The core vs. headline debate boils down to expectations, namely: if oil and energy prices (i.e., the prices excluded from headline inflation) are set for a secular rise, the value of using core inflation will mislead and misinform. On the other hand, if oil and food prices remain true to their history and continue to cycle up and down sans trend, core inflation will remain the better predictor of future inflation, as it has in the past.
But let’s stay agnostic on the question for now and consider the headline-adjusted 10-year yield on its face. That leaves us to ponder the meaning of the extreme depths of real Treasury yields. For our money, we take this as a pivotal moment in the interest rate cycle. If real yields continue falling, we may be looking at a whole new ball game of liquidity injections, the likes of which haven’t been seen since the 1970s. That suggests higher inflation.
Does that outlook mean, then, that the Fed will be compelled to tighten? An op-ed by Harvard economics professor Ken Rogoff, published in today’s Financial Times, suggest as much: “Is it not now clear that the main macroeconomic challenges facing the world today are an excess demand for commodities and an excess supply of financial services?,” he asks. “If so, then it is time to stop pump-priming aggregate demand while blocking consolidation and restructuring of the financial system.”
Nonetheless, Fed funds futures traders don’t smell a rate hike coming any time soon, as per current prices via CBOT. Perhaps by the end of the year the Fed will raise rates by a modest 25 basis points, the futures market suggests.
Meantime, there’s still an abundance of uncertainty about what comes next. Given the volatility and surprises that have become the norm in so many corners of finance and economics, handicapping the future is getting tougher by the day. Nonetheless, it seems like we’re about to enter a new phase in the global economic cycle. Alas, we don’t have a good sense of what exactly this new phase will bring.