Inflationary Expectations, the Dollar, and the 10-year Government Bond Yield

On Saturday, Allan Meltzer made the statement that “Inflation is coming.” Like the 1970s, we are in for another bout of high unemployment and inflation, which “flummoxed” the Federal Reserve’s policy committee and created a situation in which ”inflation and unemployment rose together throughout the decade.” (http://professional.wsj.com/article/SB10001424052748704709304576124033729197172.html?mod=ITP_opinion_0&mg=reno-wsj)

The market evidence for this?

“Commodity and some materials prices have increased dramatically in the past year. Countries everywhere face higher inflation. Despite the many problems in the euro area, the dollar has depreciated against the euro, a weak currency with many problems, suggesting that holders expect additional dollar weakness.”

The above chart shows that value of the United States dollar relative to the Euro. As the line rises the dollar weakens. In the early part of 2010, the Eurozone seemed to fall apart as the fiscal problems faced by sovereign governments created a financial collapse. The Euro declined against other currencies in the world.

By the summer of 2010, some quiet had returned to Europe and the Euro began to strengthen again against the dollar moderating late in the season around$1.27. However in late August 2010, Fed Chairman Ben Bernanke announced that QE2 was on the horizon and, as can be seen, the value of the dollar fell dramatically reaching the $1.40 neighborhood in November.

Although the value of the dollar rose again toward the end of the year, it again appears to be under siege as the dollar has fallen back into the $1.36-$1.37 range. So, in spite of its weakness, the value of the United States dollar seems to be losing ground relative to the Euro.

The key to this behavior Meltzer believes is the expectation of inflation. It is assumed by many that inflationary expectations get built into interest rates. I have just written on the current situation, the recent changes in inflationary expectations and the possible future movement in interest rates. See my post, “Long-Term Treasury Yields and Inflationary Expectations.” (http://seekingalpha.com/article/250838-long-term-treasury-yields-and-inflationary-expectations)

Here we have a chart the yield on 10-year Treasury securities. Note the decline in the yield that took place in the early part of 2010 to the fall. Many argue that this decline was due to a flight-to-quality as the investors left the sovereign debt of Eurozone countries and brought their money to invest in US Treasury securities.

Whereas the announcement of the coming of QE2 came in late August (and rates bounced up on the very next trading day after the Bernanke speech), the actual plan of action for QE2 was released in October and the Fed began conducting the QE2 in November. As can be seen in the above chart, the yield on 10-year treasuries has risen ever since. The last day in this chart is February 4. On February 8, the yield on the 10-year treasury security closed over 3.70 percent, a rise of 150 basis points since the late August date of Bernanke’s speech.

The argument can be made that participants in the financial markets are so sensitive to the possibility for future inflation that on the very next market trading day following the Bernanke statement, inflationary expectations began to build in the bond markets. And, the buildup of these inflationary expectations was also experienced in the market for the United States dollar and the dollar traded weaker even to the Euro even though the Eurozone was experiencing many fiscal and financial problems.
One can see this more clearly in tracing the value of the dollar indexed against major currencies. Here it is obvious that the dollar is trading at the lows reached over the past year and is even threatening the post- World War II lows reached in the summer of 2008.

It appears as if many investors in world financial markets agree with Allan Meltzer that, in fact, “Inflation is coming.” It is just the United States government that doesn’t see this.

Long-Term Treasury Yields and Inflationary Expectations

The yield on the 10-year Treasury bond closed at 3.48 percent yesterday. Just a little over five months ago the yield on the 10-year Treasury bond was at 2.48 percent, a full 100 basis points lower than the current yield. What’s happening and where are we going?


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?

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.