Tuesday, April 6, 2010

Future Long Term Treasury Rates

The ten year Treasury yield hit 4.00% yesterday, a level not hit since June 6, 2009. Then one has to go back to October 31, 2008 for the next time this yield hit the 4.00% level. The big question is, of course, where is the rate going to go from here?

Many experts claim that the outlook for longer term interest rates depends upon what is going to happen to inflationary expectations in the financial markets. With the Consumer Price Index for All Items hovering around the 2.0%-2.5% range, year-over-year, and the CPI less Food and Energy at the 1.0%-1.5% range, year-over-year, actual inflation is extremely low given the experience of the past 50 years or so.

So, what is the market anticipating in terms of inflationary expectations for the next ten years?

If one uses inflation-indexed government bonds as an estimate for the real rate of interest, then for a ten-year Treasury security the market seems to be estimating that the real rate of interest is now around 1.50%. If so, then with the nominal 10-year Treasury security around 4.00%, one could say that the market expects inflation, over the next ten year period to run about 2.5% or approximately at the upper end of the current range for the CPI for all items.

However, one could argue that the Treasury market has been the beneficiary over the past 15 months or so of two unusual forces, both connected with the financial collapse that began in the fall of 2008 and continue to this day. The first of these forces is the huge amount of funds that have flown to the United States and to Treasury securities connected with the “flight to quality” from the rest-of-the world. This “flight-to-quality” began in late 2008 and continued throughout most of 2009 with lapses here and there.

The second factor is the quantitative easing on the part of the Federal Reserve. This has helped to sustain very low market interest rates, long-term as well as short-term. The quantitative easing has also been accompanied by the Fed’s huge purchase program of mortgage-backed securities and Federal Agency securities that have provided a substantial amount of liquidity to the financial markets.

Both forces have resulted in Treasury yields that are substantially below what I would consider to be normal on a historical basis. And, these forces have impacted the inflation-indexed securities as well as the nominal-yield securities. Expected real rates of interest just do not drop to the level that the inflation-indexed securities have fallen to.

Historically, for the last fifty years, the estimate I have used for the real rate of interest tends to be around 3.0%. I won’t argue with 2.8% or with 3.2% because that is not the crucial issue. Before the 1960s, the real rate of interest seemed to be about 2.5% due to the slow growth period of the 1950s and this helps to account for nominal interest rates being so low throughout most of that period of time. Beginning in the sixties, however, the higher, 3.0% rate, seems to provide a relatively better estimate for the “expected” real rate of interest.

If one assumes that the “expected” real rate of interest for the next ten years is 3.0%, then one could argue that the current “realized” real rate of interest from the inflation-indexed securities resulting from the international “flight-to-quality” and the quantitative easing of the Federal Reserve is 150 basis points below what it otherwise would be.

Carrying this argument further, one could argue that the nominal 10-year Treasury security should be around 4.50% once the influence of the foreign “risk-averse” money and the Federal Reserve easing is accounted for. This would imply that the inflationary expectations built into the Treasury yield by the financial markets was about 1.5%, a figure that is at the high end of the current rate of inflation indicated by the CPI less food and energy costs.

But, you could go further than this. The Fed and Ben Bernanke have stated that the “informal” inflation target of the Federal Reserve is about 2.0%. If it is assumed that the Fed is able to contain inflation at this 2.0% level for the next decade, then one would assume that the 10-year Treasury yield should be around 5.0% to reflect an expectation of inflation of about 2.0%.
If the market believes that in the long run, the costs of food and energy should be accounted for in inflation, then, assuming that the upper bound of the current rate of CPI inflation for All Items, 2.5% is achieved over the next 10-years, then inflationary expectations should be at this level and the nominal 10-year Treasury yield should be around 5.5%

Of course, there is another body of thought that looks at the $1.1 trillion of excess reserves in the United States banking system and contends that there is no way the Fed will be able to remove these excess reserves from the banking system before bank loans expand excessively, money stock growth becomes extremely rapid, and inflation becomes a major problem again. To these investors, the assumption of inflationary expectations of 2.5% is ridiculous. Consequently, even a 5.5% 10-year bond rate seems excessively low.

One can argue that, as in the decade of the 2000s, many foreign countries have helped to finance the United States deficit and, as a consequence, and this has also kept United States interest rates lower than perhaps they would have been otherwise. Some analysts believe that this will continue. One can argue from many different sides of this argument for a specific level of interest rates relative to expected real rates plus inflationary expectations. I don’t really find this “supply of funds” argument convincing.

I believe that long term interest rates are headed up. How far they will go depends upon a lot of things, some of which I have tried to present in this post. If the economy continues to strengthen, I feel that the 10-year yield on Treasury securities should, over the next two years, be closer to the 6.00% level than the 4.5% level. There, I am on the record.


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