Bonds: Dropping Real Yields Indicate Inflation on Horizon

This chart calculates the real yield on T-bonds by subtracting the annual change in the Core CPI from the yield on 10-year Treasury bonds. Note that real yields were chronically low in the 1970s, and were chronically high in the 1980s and 1990s. It's not a coincidence that low real yields in the '70s occurred alongside rising inflation, or that high real yields in the '80s and '90s occurred alongside falling inflation. That's because real yields along the Treasury curve tell you a lot about how easy or how tight monetary policy is expected to be. High real yields reflect an expectation of persistently tight policy, while low real yields reflect an expectation of persistently easy money.

Tight money in the '80s and '90s kept real yields high, and high real yields meant that an investment in bonds was competitive with other investment opportunities in the economy. Thus investors had an incentive to hold bonds, and at the same time, because real borrowing costs were high, they had a disincentive to borrow money. Thus the demand for money was relatively high, and this created a relative shortage of money in the economy. With money in short supply, prices for tangible assets remained relatively low. Indeed, the CRB spot commodities index fell about 30% from the early 1980s to 2002. Not surprisingly, core inflation fell from double digits to 2% over the same period.

Monetary policy has been relatively easy for the past 5 years now, and particularly easy in the past year or two. The Fed acknowledges that monetary policy is very accommodative, and they tell us they plan to stay that way for quite some time. It's not surprising, then, that T-bonds are relatively unattractive. Looked at from another perspective, there is so much concern out there (in the market and among the Fed governors) that weak economic growth will have adverse consequences, that the market is willing to pay relatively high prices for the safety of T-bonds.

On the margin, however, these concerns are diminishing, as evidenced by the gradual decline in the Vix index, the ongoing decline in credit spreads, and the rising level of equity prices. Borrowing costs are falling for many consumers and businesses, making debt more attractive on the margin. It all adds up to falling money demand, even as the Fed resists tightening money supply. The result is a relative abundance of money, and we see the signs of this in rising commodity prices. We should expect other tangible asset prices, such as housing prices, to begin to rise as well, probably by the end of this year if not sooner. The last shoe to drop will be rising inflation, of course, since it takes time for monetary policy to flow through the economy and hit the CPI. The only thing that is not apparent in all this is how soon inflation will rise, and by how much.

Comments

[Larry House:]

Something we have to watch is if Bernanke is reappointed. If he is, I think he will do all he can to fight inflation. If he is not reappointed, I look for the Obama puppet to keep rates low longer to build a roaring economy, if possible, and inflation will run out of control. Heaven help us all if that happens.

Jul 27 03:01 PM

[EMS News:]

NO Fed chief tries to kill inflation until it is way too late. They live for inflation. They fear depressions because then, people begin to ask questions about the Fed even existing.

Jul 27 03:40 PM

[Living4Divi...:]

Great article - I find the graph especially valuable.

Amazing how real interest rates were between 7%-9% in the mid 80's. This is due to inflation expectations of the late 70's early 80's.

Jul 27 03:59 PM

[WhoisJohnGalt:]

Bernanke has been playing the pessimist hoping to throw enough money into the system to stave off Great Depression 2.0. Although a Fed member has been talking today about increasing rates, it is not in Bernanke's blood to make a quick turn on what is still an uncertain recovery. So frankly, I'd have to go with the reverse prediction of what you said Larry.

Jul 27 04:02 PM

[Erwan Mahe:]

Incredible twist you do there mr ! if real yields are low, when Core Cpi is itself low, it is not that because bonds buyer accept a low nominal yield ? And don't they do that because they except core Cpi to stay low or go even lower. Do not forget where the nominal CPI is now ! And regarding commodities, do not look at the FED, just observe the Chinese piling up on Copper, Oil, Iron ore and else, going through their own stupid Minsky way, or Politburo's way I should say...

Jul 27 04:40 PM

[robert.b.fe...:]

I wouldn't look for real estate values to go up any time soon. While residential may be close to a bottom commercial is just starting to fall. Given that this has been cooking for at least two years and the average real eastate recovery takes at least five years I would guess we have a couple of years to go before residential real estate makes a significant recovery.

Jul 27 04:57 PM

[lukeseefeldt:]

Now that the Fed has threat of being audited mark their threats...they way they would have to raise interet rates and that this would have dire repurussions.

If that is a threat, they view it as a negative thing to do.

If they view it as a negative, they will keep easy money the status quo.

Watch out 2011. The poor will be poorer at the expense of the rich, a new kind of socialism.

Jul 27 05:29 PM

[Dian L. Chu:]

Essentially, the Fed is experimenting on what drives inflation: the money supply or the output gap, and is betting on the economic contraction would keep inflation low. However, the core US PPI rose 0.5% from May, the biggest rise since October 2008, while the core US CPI was up 1.7% Y/Y. So, it looks like the liquidity the Fed has injected could begin to pose an inflationary threat unless the FOMC pares it down and raises interest rates.

More realistically, the Fed will likely be slow to soak up the liquidity, in part because of the still- high unemployment. The U.S. is still in the early stages of recovery, so we've got a lot of reflation ahead of us, and ultimately could end with double-digit inflation.

Jul 27 07:11 PM

[Brian27:]

These are ex-post real yields which differ from expected real yields. Expected real yields, nominal yields minus expected inflation are the variables investors and monetary authorities base decisions upon. To get a measure of expected inflation use the yield on indexed bonds and subtract nominal yields. Then construct an expected real yield curve. The difference between the expected and ex-post real yields will measure inflationary expectations mistakes.

Jul 27 07:17 PM

[anarchist:]

Dian, I respect your work and follow your postings but I disagree with your statement "More realistically, the Fed will likely be slow to soak up the liquidity". I went ballistic over the moves the Fed made early on in the financial crises and I still think Geithner's appointment to the Treasury was a mistake, but I have come to respect Bernanke and I think he will be able to soak up the excess liquidity long before double digit inflation.


On Jul 27 07:11 PM Dian L. Chu wrote:

> Essentially, the Fed is experimenting on what drives inflation: the
> money supply or the output gap, and is betting on the economic contraction
> would keep inflation low. However, the core US PPI rose 0.5% from
> May, the biggest rise since October 2008, while the core US CPI was
> up 1.7% Y/Y. So, it looks like the liquidity the Fed has injected
> could begin to pose an inflationary threat unless the FOMC pares
> it down and raises interest rates.
>
> More realistically, the Fed will likely be slow to soak up the liquidity,
> in part because of the still- high unemployment. The U.S. is still
> in the early stages of recovery, so we've got a lot of reflation
> ahead of us, and ultimately could end with double-digit inflation.

Jul 27 07:38 PM

[MarvinMBA:]

5 percent for 5 years is the magic numbers I use before buying bonds including T's...sooner or later the first five will be 7 and then 8....MarvinMBA

Jul 28 12:16 AM

[Adam855:]

Bernanke is an academic who studied the Great Depression, and has openly admitted his flood of liquidity and loose monetary policy was heavily influenced by not wanting to make the same mistakes as the Fed in the 1929 time frame, when they tightened money supply. In addition, conventional wisdom says that in 1936-1937 the Fed made another series of errors in increasing reserve requirements while the economy was still too fragile, adding more years onto the economic malaise.

I'd be willing to bet that Bernanke is very reluctant to tighten again due to his background with the above. All of his past speeches say that he's much more willing to error on the side of inflation than deflation.

Jul 28 12:26 AM

[spqrusa:]

Nice graph - there is more to read from it. First, I agree that Bernanke, if reappointed, would focus on keeping inflation in a manageable target zone, even if they have to fudge it a bit more than they already do.

Lots of money was added across the money supply in the 70's - this inevitably lead to systemic inflation. The difference with today is the way the Fed expanded. Much of the new money was added in M3. The stimulus monies are small in relative terms to previous stimulus streaks.

It really comes down to how Banks lend in this environment, and how the majors allocate money flow. The environment is still ripe for speculative distortions, but there are (supposedly) tighter oversight into money flows.

Obama doesn't seem like a risk taker. He will keep Bernanke. Obama will probably pull for housing stimulus behind the scenes since it supplies much of the back drop for middle class wealth. If the middle class feels worse in 3 years, he will have a tough sell.

Jul 28 02:36 AM

[rick12345:]

the fed openly admits that it has embarked on a policy for a low usd, resulting in higher levels of inflation. unfortunately you cannot have increased levels of business investment without it affecting the cost of inputs. once company stockpiles are exhausted expect rising inflation, unless of course the gov't wants to risk the possibility of a double dipped recession. There is no easy road out of this mess unfortunately, other than a tightening of both monetary and fiscal policy once the economies of the world finally get out of third gear; at the moment we're still stuck somewhere between reverse and 1'st, but fortunately the wheels are moving forward.

Jul 28 06:38 AM