Last week the Federal Reserve signaled the next step in its strategy of quantitative easing to rescue the economy. The Fed says it will reinvest payments on mortgage assets it holds into Treasuries. Not surprisingly, yields fell. The 10-Year Treasury index (TNX), for example, closed the week down 4.6% from its level the hour before the Fed announcement.
Of course, the trouble in Treasury Land goes back much further. The August 13th TNX close was 32.6% below the 2010 high on April 5th.
Let's take an even longer perspective. The chart below shows the 10 Year Constant Maturity yields since 1962 along with the Federal Funds Rate (FFR) and inflation. The range has been astonishing. The stagflation that set in after the 1973 Oil Embargo was finally ended after Paul Volcker raised the FFR to 20.06%.
Click to enlarge images
Now let's overlay the S&P 500 to see historical pattern of equities versus treasuries. This is a nominal chart, which significantly distorted the real value of both yields and equity prices.
Here's the same chart with the S&P 500 adjusted for inflation and the annualized inflation rate subtracted from the yields. The impact of stagflation becomes much clearer. We can better understand the severity of the decline in equities from the mid-1960s to the bottom in 1982. And we can also see why high yields can be deceptive in periods of double-digit inflation.
The most interesting series in the charts is the FFR red line. We can see how the Fed has used the rate to control inflation, accelerate growth and, when needed, apply the brakes. Unfortunately, the FFR has been virtually zero since December 2008, so it is no longer available as a tool to stimulate the economy. Incidentally, I annotated the top chart with the tenures of the last three Fed chairmen so we can see who was managing the various FFR cycles since the summer of 1979.
The next chart adds some additional Treasuries for a close-up of yields since 2007.
As we can see in the last chart, Treasury yields have occasionally led the market. They began sliding in August 2007, a couple of months before the nominal all-time market high. They bottomed in late 2008, nearly three months before the March 2009 market low. However, the most recent slide started only two weeks before April 23 market high. Since that time, the slope of the decline is uncomfortably similar to what we experienced in the summer of 2008. How the Treasury bond market plays out over the next few months will be of critical importance to equity markets and the economy as a whole.