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When Will “Normal” Bond Yields Return?

By: Jeff Goble

Have you noticed that, after inflation, 10-year U.S. Treasury bonds currently yield a negative real return? With the annualized inflation rate via the Consumer Price Index hovering around 1.70 percent and Treasury yields at 1.40 percent at the time of this writing, fixed-income investors are now losing 30 basis points of yield after inflation. How long can this last?

Probably for a while, it seems, but if history is a guide … not forever. There is so much global uncertainty and slack demand now that cash is flowing in record amounts to the safe haven of U.S. Treasury bonds and the dollar. Add in the Fed’s massive trillion-dollar quantitative easing programs (QE1, QE2 and the Twist) that have driven yields very low and it makes one wonder when the yield spread over inflation will return to normal.

My research shows that during the past five years, the normal spread of 10-year Treasury bonds over inflation has been a positive 103 basis points. This would mean a “historically correct” 10-year Treasury note yield should be 2.43 percent now. This is one way of quantifying the fear in the Treasury bond market now in basis points. We actually touched this yield level in March before the recent economic dark clouds rolled in domestically and in Europe.

You can see in the chart below how this average spread has widened and narrowed over longer periods of time, which I think is very interesting. The big question now is which time period should we rely on going forward to apply the average historical spread. Should it be the five-year average or the 50-year average? Which is more accurate?

What exactly is causing the relationship of bond yields versus inflation to narrow over time? I think there are a number of reasons. First, besides the Fed’s historic bond buying programs, future expectations about inflation are changing dramatically as we have seen actual signs of deflation through the recent recession. It is hard now to believe that inflation actually averaged 14 percent in 1981 … but since then has been in a secular decline over the past three decades to today’s historically low 1.70 percent level. You can see the effect of the double-digit inflation years in the ‘80s in the higher 30-year average spread in the chart.

Second, the dollar and U.S. Treasury bonds have become the world’s safe haven. Because of uncertainty in Europe, investors have exited the euro and purchased dollars via Treasury notes in record amounts for safety, thus driving rates to historic lows and through the inflation rate. Return of principal is suddenly more important than return on principal on a global basis. This is temporary, in my opinion.

Third, globalization has meant that the world is a much smaller place and the barriers for commerce have been greatly reduced and cash and products can move much more easily and quickly. The Internet and the media have been powerful tools in the globalization process that has been underway for many years. The world seems smaller and more interconnected every day and our economy is still the obvious leader.

What I worry about most now is what might happen if the reversal of this massive and historic shift toward safety over the past four years does not occur in an orderly fashion.

Can the Fed manage downsizing its $3 trillion balance sheet in a way that does not disrupt markets? As bond investors, let’s hope!

It seems to me that the historically poor risk-reward tradeoff available in the Treasury bond market now strongly suggests patience, thinking long term, avoiding new security types or long maturity bonds for extra yield and focusing on high-quality investments as outlined in your bank’s investment policy.

Trust it.

Jeff Goble is executive vice president and managing director, investment banking, at UMB Bank, n.a., Kansas City. His email address is Jeffrey.Goble(at)umb.com.

Copyright (c) September 2012 by BankNews Media


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