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The problem with Treasury yields

I'm always on the lookout for valuation discrepancies, and these two charts highlight the biggest potential discrepancy that I'm aware of today: Treasury yields are very low given the strength of the economy and the level of inflation. Stock prices are rising because the economy is proving to be somewhat stronger than expected. Inflation is not dead—it's been rising for the past year—and it now is close to where it's been for the past decade, around 2-3%. Yet bond yields are near all-time lows and are priced to the expectation that the economy will be chronically weak and inflation will move towards zero. 

There are of course three valid explanations for why Treasury yields are so low despite the improvement in the economy and the outlook for 2-3% inflation (i.e., the market is not entirely crazy): 1) the Fed keeps insisting that it will keep short-term rates near zero for the next three years, 2) the Fed, via its "Operation Twist," is actively attempting to keep Treasury note and bond yields low, and 3) the world is willing to pay very high prices for the safety of Treasuries given the threat of Eurozone sovereign defaults and the potential demise of the Euro. 

However, those rationales could evaporate very quickly, if a) the Fed becomes convinced that the economy is doing better than expected and there is little risk of inflation being too low, and b) the Eurozone survives a Greek default without any significant collateral damage. I think there is a reasonable chance we could see both of those developments within a reasonable time frame. Thus I view Treasuries as very risky investments, while equities remain relatively attractive, underpinned by relatively low PEs and strong corporate profits.

UPDATE: There appears to be some confusion regarding the market's expectation of future inflation, and I should have made that clear in my initial post. The best measure of expected inflation that I know of is that which is derived from the pricing of TIPS and Treasuries. And the Fed agrees, having annointed the 5-yr, 5-yr forward inflation expectation implied in TIPS and Treasury prices as the "best" measure of the market's inflation expectations. I show that in the chart below, with the current reading being about 2.5%. On a longer-term basis, the expectation for average CPI inflation over the next 10 years is about 2.25%. Both of these expectations are very close to what inflation has averaged in the past 5 and 10 years, so there is nothing unusual in today's expectations for the future. 

You can see the same pattern in this chart as in the charts above: 10-yr yields are trading substantially below the level that has prevailed in the past, given current inflation expectations. No matter how you look at it, Treasury yields appear to be artificially depressed. And from my perspective, the pressures for higher yields are building daily. 

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