Bonds Priced to 2% Inflation

click to enlarge

This chart is set up so that when the two lines overlap, a 30-year T-bond will pay you 2 percentage points more than core inflation, as measured by the CPI. Many would consider that to be "fair value," since over long periods that is about what the real return on long-term Treasury bonds has been. As you can easily see, however, for most of the past 20 years T-bonds have yielded much more than their fair value yield, until recently. Right now you could say that T-bonds are trading at fair value, if you believe that core inflation is going to remain around 2% forever.

If inflation rises, however, T-bonds are going to deliver miserable returns. Either their yield will remain low, lagging the rise in inflation (in which case their real yields will be less than 2% per year or even negative), or yields will rise as inflation rises and the price of the bonds will fall. In the case of the current 30-year T-bond, its price will fall about 17% for every 1 percentage point rise in yields. Just a modest rise in inflation and yields could wipe out several years of coupon payments.

Since early 1980 and up to the end of last year, T-bonds delivered excellent returns, but that was mainly because their yields were much higher that inflation, and declining. Returns were excellent because the bond market was chronically over-estimating the rate of inflation. Now the bond market is betting that inflation will remain around 2% forever. Importantly, the fears of deflation which pulled bond yields down at the end of last year have all but vanished. But the bond market is not at all prepared for an eventual rise in inflation.

Caveat emptor.

Disclosure: I am long TBT at the time of this writing.

Comments

[Prudent Man...:]

If you want "rent" on your money of 2.5-3% short-term rates at 2% = 4.5-5% vs. virtually nothing now. So much for rational markets when government intervenes to rape the saver and retiree in favor of the profligate and parasite. Liberals are so liberal with other people's money while they skim a big portion for themselves. What an utterly immoral concept. Shame, only they have no shame!!

Jun 17 03:57 PM

[Prudent Man...:]

I meant if inflation is 2% short-term rates should be 4.5-5% now! What are the odds that inflation will be substantially higher next year.? One year T Bill should be priced accordingly if we were in a Free Market. Government manipulated markets, from treasury rates to commodity price fixing and ration, as we will so see in health care, have always ended in disaster.

Do bureaucrats, academics and politicians know more about markets than those who have to deal every day with their goods and service, their livelihoods, do? I am talking about businessmen not market traders. Not a chance!!

Jun 17 04:06 PM

[bugsy:]

Obama and his people may be doing the wrong thing, but dont forget what the other side did to get us in this huge mess. Bush and his cronies were the worst in our history.

Jun 17 04:14 PM

[Sean Mc:]

Bugsy,

I don't disagree with you but I find those types of comments totally destructive. As we all know, politics have become much more polarized in the last 10 years or so. By tradition, politicians campaign to the center. But nearly anyone who advances to high office at the local, state or national level is beholden to the party and special interests that have backed them throughout their careers. Therefore, politicians once in office tend toward the extremes rather than the center that represents the vast majority of the public.

When political tides change and a party regains power after years in the minority, most of their energy seems to be spent blaming their predecessors and reversing laws and policies of the previous administration. Increasingly politicians are blatantly acting as though they represent only those citizens who share their political affiliation. They act spitefully, not just toward the politicians across the aisle, but even to their own constituents who have different party affiliations. I don't think the two parties are any different in this regard. Those of us in the center have no representation in government any more. In fact, we usually end up as easy targets for both parties.

I am not a cynical person by nature. But I think this infighting has damaged our democratic process almost to the point of destruction. I do believe that this cycle can be broken but it will probably take a grass roots effort from those on both sides who are willing to truly acknowledge that we are all in this together, and are able to put themselves in the shoes of those on the other side.

On Jun 17 04:14 PM bugsy wrote:

> Obama and his people may be doing the wrong thing, but dont forget
> what the other side did to get us in this huge mess. Bush and his
> cronies were the worst in our history.

Jun 17 11:43 PM

[Mad Hedge F...:]

Makes no sense to me. I have watched many countries go bankrupt over the years, as my collection of defaulted bonds hanging on my wall attests. Governments borrow so much that the cost of the debt service exceeds the national budget, so the country has no choice but to quit paying. I am starting to see disturbing parallels here. Bush took the national debt from $5 trillion to $12 trillion, and Obama will inflate it to $17 trillion by the end of 2010, boosting it to a frightening 82% of GDP. The cost of the borrowing is rising too. Today a 1% jump in bond yields raises the federal interest burden by $50 billion. The Congressional Budget Office says that figure will explode to $170 billion in ten years. Can you see the same hockey stick, hyperbolic, exponential growth in obligations that I do? Interest rates will soar to double digits, the dollar will crash, and private borrowers will get crowded out of the market, taking the economy into the tank. People blanche when I tell them that my target for the PowerShares US Lehman leveraged short government bond ETF (TBT) is $200, but the logic is inescapable.

Jun 18 11:56 AM

[LKofScotland:]

why bail out a wall street that refuses to agree to contracts negotiated with each other in so called good faith? because the government itself understands that game better than anyone. clearly all we have now is a tyranny--perhaps thankfully of the merely corrupt. Should the goods and services stop flowing over our transportation network, however, which is possible should the price of oil reach a sufficiently high level, you will see the other side of government which is not the "we the people" side that democrats like to portray themselves as but as "i'm part of this aggrieved minority and now i have the biggest monster in human history on my side and now i will unleash him on all of you." Getting rid of the Office of Thrift Supervision? Creating one regulator to prevent "systemic risk"? The government itself is the systemic risk. We need the same bureaucracy's watching each other because that is the only solution to government being the problem. Isn't it obvious that government must blame the banks because they've been in bed with them for over 20 years! My God the inflation that is being created RIGHT NOW is incredible. It is the ONLY way this spending orgy can be paid for. Government will never allow interest payments not to be made. Instead government MUST inflate the deficit away because it's the "least disagreeable" economic plan for big government types. Add in massive trade deficits and OF COURSE not only must we have inflation but we must have bailouts too. Only mega-businesses (oil, natural gas companies, giant food mfg's and Wal-Mart) and most importantly mega-banks (apparently there will be only one in JP Morgan) are capable of handling such incompetence on such a grand scale. the rest of us? insofar as economic policy is concerned uncle sam is telling "us" to simply die. Amazingly we're the majority!

Jun 18 02:04 PM

[suppose:]

LK:

All of this disaster is being directed by a President who has no, I repeat, no experience in business, finance, or managing his own affairs. His only experience is "organizing," i.e., getting out the vote.

Jun 19 01:43 PM