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More proof the market is extremely pessimistic




For quite some time, I've been making the case that the very low level of yields on 10-yr Treasuries was symptomatic of a market with very low expectations for real GDP growth (see the 5th chart in this post for an example). This chart says the same thing, except that it uses the real yield on 10-yr TIPS to make the point. My inspiration for this chart came from an article in today's WSJ by Jeremy Siegel and Jeremy Schwartz, "The Bond Bubble and the Case for Stocks," in which they note that:

The yield on the benchmark 10-year TIPS [recently] turned negative for the first time in history, meaning investors are now lending money to the government with the hope of receiving a sum 10 years from now that is worth less in purchasing power than the dollars they fork over today. This astounding situation can only be justified by extraordinary pessimism about the prospects for the U.S. economy. Economic theory predicts that the real yield on long-term TIPS should approximate the real growth in the economy.

The chart above illustrates that the real yield on 10-yr TIPS has indeed tended to track the real growth of the economy. Note that in the early years when TIPS were first issued, real yields were very close to the economy's real growth performance in the go-go years leading up to the 2001 recession. Following the 2001 recession, real yields settled in at around 2%, foreshadowing the relatively subdued recovery that followed, and the modest growth that led up to the 2008 recession. Now real yields have plunged to zero, suggesting that real growth going forward is going to be either nonexistent or quite dismal. This is indeed troubling, considering that the economy is currently operating about 10% below its potential, or long-term growth trend. Without growth, the unemployment rate, which is still exceptionally high, could reach depression-era levels in the years to come.

Siegel and Schwartz go on to note that despite the economy's recent difficulties, corporate profits are at record levels, and that dividend yields are likely to rise over time even if the economy struggles and even if our debt woes lead to more inflation, thus making dividend-paying equities an attractive alternative to the deep pessimism built into bond prices. Looked at from another perspective, if the economy merely avoids a recession or depression, then Treasury and TIPS yields are likely to rise significantly.

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