Two extraordinary factors are impacting Treasury yields at the present time and have been there for quite some time now. The first of these is the effect that the quantitative easing of the Federal Reserve is having on market rates. The second is the “flight to quality” that has kept the yields on Treasury securities below what they otherwise might be. How do I account for these two factors?
Well, first I start out with a “rough” estimate of the real rate of interest. The base figure that I have used for years has been 3.0 percent.
(I just found out this morning that this is similar to what my former colleague Jeremy Siegel,
Professor of Finance at the Wharton School, UPENN, uses: http://www.ft.com/cms/s/0/00d6f8d0-2ec7-11e0-9877-00144feabdc0.html#axzz1Chh2pOYC.)
This figure, the 3 percent estimate is a “before-the-fact” estimate and therefore is a long term expectation. An “after-the-fact” estimate is often made by taking the nominal rate of interest, say the roughly 3.5 percent mentioned above and then subtracting actual inflation from this figure. This is “after-the-fact” because the numbers used to calculate the real rate have already occurred.
The 3 percent estimate is important because it can be compared to another, so-called, real rate of interest, the yield on inflation-protected securities, called TIPS. Yesterday, the yield on 10-year inflation-protected securities was 1.04 percent at the closing, substantially below the 3 percent estimate.
Siegel, I believe rightly, calls our attention to this discrepancy because he believes that the current yield on inflation-protected securities must rise toward the higher number and this will mean that the holders of these securities may suffer substantial capital losses on the securities because the price of the securities must decline to allow the yield to rise.
Investors are not fully aware that this decline might happen in this area of the bond market.
The difference between the current market yield on these securities and the “before-the-fact” estimate of the real rate of interest represents the impact that the Fed’s quantitative easing along with investor’s “flight-to-quality” is having on the current market yields. If this is true then the nominal bond yields in the market are roughly 200 basis points below where they would be without the Fed’s actions as well as including the international flight to safe United States Treasury issues.
If this is the case then we could argue that the yield on the 10-year Treasury security should be around 5.50 percent rather than 3.50 percent.
If this is the case then the longer-term “inflationary expectations” that investors have built into market yields would be around 2.5 percent.
The question then becomes, is this estimate of inflationary expectations “in the ball park”?
I like to look at the year-over-year rate of change of the GDP price deflator as my estimate of the rate of inflation because I have less concern that this figure is being “messed” with than the more popular Consumer Price Index. Looking at this measure of actual inflation we see that inflation does seem to be picking up.
In this chart we see that the rate of inflation is picking up and is now just below 1.5 percent. We can note that once inflation starts to pick up, it does not reverse itself in the near term. Furthermore, looking at the performance of inflation over the past ten years, an inflation rate of 2.5 percent is not unreasonable for a moderately growing United States economy. And, remember, this 2.5 percent can be interpreted as the compound rate of inflation over the next 10 years, a period far beyond the inflation that might be experienced over the next year or so.
Added to this is the fact that inflation is picking up, not only in the developed countries in the world, but also in the emerging countries. Inflation in the Eurozone is running a little above 2.0 percent, in the UK, a little under 4.0 percent, and in China and India, the rate of inflation is now in excess of 5.0 percent. Thus the trend in the world is for increasing rates of inflation.
My rough estimate that the yield on the 10-year Treasury bond should be around 5.50 percent in 2011 is slightly above the forecast I presented earlier. (See “Long-Term Treasury Yields in 2011: http://seekingalpha.com/article/243018-long-term-treasury-yields-in-2011.) The reason for this change, I believe, is that investors, world wide, are believeing that inflation is becoming a bigger problem than earlier expected. The European Central Bank has ceased its special purchase program of securities because of the rising concern over price increses. The Bank of England has experience similar concerns. The only central bank that does not seem concerned yet is the Federal Reserve.
And, of course, my forecast assumes that the Federal Reserve will, at some point this year, back off from quantitative easing.
But, why should we expect the Federal Reserve to back off from QE2 any time soon? Chairman Bernanke has been late on every shift in monetary policy since he has been a member of the Board of Governors. Why should we expect anything different this time?
1 comment:
I think the bigger/better question is CAN Bernanke stop QE'ing. The Treasury has to sell treasuries. That what happens when you deficit spend. Somebody has to loan them money. And ... if interest rates go up, that will increase the money that will need to be borrowed as well.
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