How Real Is the 10-Year's 'Real' Yield?

The highest real (inflation-adjusted) yields in 15 years for Treasuries are boosting demand, Bloomberg reported at the end of last month.

Halfway through August, there's no reason to think otherwise. The 10-year's yield hasn't changed much in recent weeks, closing yesterday at roughly 3.59%. Meanwhile, inflation, as defined by the consumer price index, appears in no imminent threat of rising.

The July CPI report shows that inflation was flat last month, the Bureau of Labor Statistics tells us today. For the 12 months through July, CPI was negative to the tune of -1.9%, the steepest fall in 60 years.

On the surface, it looks like deflation is roaring. But this bite is worse than it appears. The year-over-year comparisons for CPI are troubling, but it's temporary. Recall that oil prices hit an all-time high in July 2008. The energy driven inflation wave, as it turned out wasn't set in stone either. But the damage to the inflation numbers had been done and the legacy intact. As a result, comparing overall prices today with those of a year ago is doomed to reflect sharp price declines unless oil prices kept rising, which they obviously did not.

Indeed, energy prices fell sharply after peaking in the summer of 2008, along with prices of virtually every thing else over the past year. A repeat performance isn't likely, or so the stabilizing global economy suggests. Indeed, the price of crude seems to have found stability too. The implication: inflation won't be falling on a year-over-year basis when we look at the numbers 12 months hence.

Barring a sudden reversal of the stability that seems to be settling into the economy, the year-over-year CPI change is likely to be showing more modest comparisons by the end of this year and through 2010. Why? Because, you may recall, the world fell apart in the second half of 2008, dragging price levels generally down the rat hole. Once we get to December 2009's CPI numbers, however, we're likely to see the case for deflation looking a heck of a lot weaker if not evaporating completely, assuming we don't resume an apocalyptic decline, which looks unlikely at this point.

Meantime, adjusting the 10-year Treasury Note by 12-month changes in CPI makes for an alluring chart, as our graph below shows. For July, the 10-year's CPI-adjusted yield was 5.46%, up from September 2008's negative 1.25%.

By the available numbers, buying the 10-year looks like a no-brainer. Prices generally are falling by nearly 2% a year. Meanwhile a nominal 10-year Treasury offers well over 5% real. A great buy, right?

We're suspicious. Unless you're expecting deflation to roar on, which we don't, the real yield in nominal Treasuries looks like a trap. Here's our reasoning. First, only nominal yields are set in stone with nominal Treasuries, which means that real yields for this series of government bonds can and does fluctuate.

For instance, let's say you bought the nominal 10-year Treasury at last night's close of 3.59%. Using the latest CPI report for July, that translates into a real yield of 5.49%. Nice. But imagine a year from now that CPI's running at, say, a positive 2% year-over-year pace, which isn't beyond the pale. Net result: your current real yield of 5.49% evaporates to 1.59%. (Remember, the nominal yield of 3.59% at the purchase date is fixed; only the inflation rate changes.)

As it turns out, a 10-year TIPS currently offers a similar real yield — 1.80% as of last night's close. The big difference: the 1.80% real yield for the TIPS is fixed whereas the real yield for nominal Treasuries changes.

The bottom line: Unless you're expecting deflation to continue or get worse, the real yield in the nominal 10-year looks dubious. Does that mean you shouldn't own Treasuries? No, since government bonds serve various purposes in a multi-asset class portfolio. But buying solely for the high real yield of the moment is too speculative at this juncture, at least for this observer.

To be fair, no one can predict inflation with any certainty, and so a passive investor would own TIPS and nominal Treasuries as a hedge. Otherwise, this is no time to bet the farm on conventional Treasuries. Sitting on huge gains over the past year — indeed, over the past generation — the hour is late for expecting continued success with "risk free" bonds sans inflation protection.

Comments

[Gardener:]

I wouldn't bet the farm on anything but I do appreciate your well reasoned article. We are in the very uncomfortable position of having nowhere to store wealth. The dollar destruction, Treasury over issuance, high equity P/Es, artificially low interest rates, PM manipulation and a real estate market that is being propped up by the government. The Fed and Treasury are obscuring all these markets and telling us it's for our own good. I trust the market to price risk and right now that's impossible. This kind of intervention is criminal.

Aug 14 03:43 PM

[Prudent Man...:]

The Fed is probably stealing 100 basis points from the saver by its manipulation of bond and mortgage prices with further debt secured with Geithner's signature.

The Woodstock Generation still hasn't come out of their fog.

Aug 14 05:29 PM

[Jasper M:]

I wonder how it is one can doubt that "delfation will roar". The only way for deflation Not to roar is if the money supply somehow stays steady, and most of that money supply is credit, with interest due. That means that for all that credit to maintain its current value (= avoiding deflation) all that interest must be paid.

How, exactly, is that going to happen?
1) Unemployment = lack of earnings to consume, = less $ to pay off loans
2) Real estate valuations crushed back into normalcy, and gun shy banks, mean no easy source of more collateral
3) the "money" that the Fed is creating is mostly just more credit (by a Huge margin!), so that won't help.

Aug 14 05:50 PM

[The Geoffster:]

Good article. The Fed will do everything in its power to defeat deflationary forces in the economy. At some point (2,3,4 years?), monetary policy will win out and we will all be wearing WIN buttons. If you don't know what those are, ask your parents.

Aug 14 08:30 PM

[chap08:]

Jasper

I'll tell you why I doubt that "delfation will roar". It is because:

1. The events of the last year set the scene for potentially the worst deflation we have ever experienced. Yet the actions of the Fed seem to have prevented anything but slight defaltion.

2. The Fed have made it crystal clear that they will prevent deflation "whatever it takes". Read Bernanke's speach "Deflation: Making Sure "It" Doesn't Happen Here ". Among the many gems you will find there are the words:

"Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost."

The paper goes on to show how fiscal and monetary measures could be combined to achieve money-financed tax cuts and the purchase of private assets with freshly printed money.

3. The Fed know that inflation is now our only option. We are too indebted for any other course of action. Debt is our biggest problem, so the Fed will reduce the size of this problem through inflation.


On Aug 14 05:50 PM Jasper M wrote:

> I wonder how it is one can doubt that "delfation will roar". The
> only way for deflation Not to roar is if the money supply somehow
> stays steady, and most of that money supply is credit, with interest
> due. That means that for all that credit to maintain its current
> value (= avoiding deflation) all that interest must be paid.
>
> How, exactly, is that going to happen?
> 1) Unemployment = lack of earnings to consume, = less $ to pay off
> loans
> 2) Real estate valuations crushed back into normalcy, and gun shy
> banks, mean no easy source of more collateral
> 3) the "money" that the Fed is creating is mostly just more credit
> (by a Huge margin!), so that won't help.

Aug 15 03:40 PM

[whidbey:]

Will, it has always been this way with bonds. What is your point?

Tips are subject to manipulation when the government plays with the calculation of CPI. The motivations to play with the numbers are many. If CPI is steady SS is cheaper, government pensions are steady, and yes the Treasury inflation payments on TIPS is low or zero. I think there is a bias to reporting low or no inflation, don't you?

Nothing on the face of a bond guarantees real yield, and if it were guaranteed would you believe it? Hope not.

Aug 17 03:57 PM