High Inflation/Falling Nominal Yields Mean Lower Returns on 10-Year Treasury

by: Russ Koesterich, CFA

Last week, world equity markets suffered their sharpest correction since August of 2010. Continuing unrest in the Middle East and lingering sovereign debt issues in Europe are contributing to the spike in volatility, but last week’s sell-off was primarily driven by the unprecedented destruction wrought by the earthquake in Japan and related concerns over the safety of its nuclear power plants. While the humanitarian cost is incalculable, we do not believe that the events in Japan are likely to meaningfully detract from global growth, or change the market dynamics favoring equities. In fact given the recent flight to safety and accompanying drop in nominal bond yields, we would be even more inclined to reiterate our preference for equities over bonds.

Japan: Both Local and Global Economies Likely to Prove Resilient

Japan will recover. In fact, the experience of the 1995 Kobe earthquake suggests that economic recovery may be swifter than anticipated. That said, lingering concerns over demographics, politics, and deflation are likely to continue to put long-term pressure on Japanese equities.

The full humanitarian costs of the recent earthquake and tsunami will not be known for months. In addition, a more significant nuclear event at the Fukushima Dai-ichi plant adds another unpredictable element to the disaster. However from an economic standpoint, absent a Chernobyl type meltdown which at this point seems highly unlikely, the economic impact of the earthquake is likely to prove modest. The area primarily impacted by the quake accounts for a relatively small portion of Japan’s economy, and Japan’s overall share of the global economy has contracted sharply after several decades of economic stagnation. Back in the 1990’s Japan accounted for approximately 18% of global economic activity. Today Japan contributes less than 9% to the global economy, suggesting that the impact to global economic growth is likely to be limited.

Given the potential for resilience, and the extraordinary efforts by the Bank of Japan to inject liquidity into the monetary system, is Japan a buy? The market is certainly cheap. Japan trades at its book value, versus the global average of 1.7x book-value for the MSCI All Country World Index. Despite its modest valuation and the prospects for a quick recovery, we believe a bounce in the Japanese markets is likely to be short-lived. The long-term issues that have resulted in what are now several lost decades are likely to persist. Namely, Japan is still facing the world’s most challenging demographics, entrenched deflation, and a political system still mired in inertia; none of which support a long-term improvement in Japanese equities.

U.S. Treasury Market: "I can’t eat an iPad"

Broad inflation in the US is unlikely to prove a threat in 2011. However, other measures of inflation are rising, particularly expectations of future inflation. The recent rise in inflation expectations reflects the sharp spike in oil prices as well as continued skepticism towards Fed policy. Rising inflation expectations imply that the real return on Treasury notes and bonds is likely to be well below the long-term average. In other words Treasuries appear particularly expensive at the same time that structural deficits will necessitate more and more supply. As a result, we would prefer municipal and corporate bonds over Treasuries.

At a recent town hall meeting in Queens, New York Fed President William Dudley was reminded that economists don’t always reside in the same world as everyone else. The event was reminiscent of the early tea party events – just substitute "quantitative easing" for "ObamaCare" and "rising food and energy prices" for "rising healthcare costs." While extolling the virtues of falling technology prices, a member of the audience responded, "I can’t eat an iPad."

The Fed tends to focus on core inflation – a measure of inflation which excludes food and energy prices – but with food and gasoline prices rising most people have a somewhat different view of inflation. And while the benefits of cheaper technology are manifest, Mr. Dudley was reminded that most people are more concerned with eating and putting gasoline in their cars.

The impact of the recent spike in energy is not just evident in town-hall meetings; these concerns are becoming more pervasive in a way that should start to alarm the Fed, or at the very least bond investors. The University of Michigan tracks many measures of consumer sentiment, including consumer expectations of inflation. In February, the survey indicated that expectations for U.S. inflation over the next year rose to 4.6%, the highest level since August of 2008 and well above the twenty-year average of 2.9%. While the one-year expectations tend to be volatile, even the more stable measure of inflation expectations- the five-year measure – spiked higher. February’s reading indicates that the survey respondents expect U.S. CPI to average 3.2% over the next five years, a level well above the Fed’s implicit inflation target of around 2%.

Rising inflation expectations are good to a point, particularly to the extent they indicate a waning fear of deflation. This was, after all, one of the stated goals of QE2. However, there can be too much of a good thing. If higher inflation expectations prove more than a passing response to an oil spike, they will eventually push consumers towards looking for higher wages, a much more serious problem. While higher wages are unlikely in the near term due to an anemic labor market, a long-term rise in inflation expectations would be a negative for bond holders.

(Click to enlarge) Source Bloomberg 2/28/11

Rising inflation expectations are also evident among professional investors. The embedded inflation rate on 10 year TIPS is now close to 2.50%, the highest since December 2009. This suggests that investors expect inflation of approximately 2.50% over the next decade, a level well above the long-term average of 2.00% that has persisted since the inception of TIPS market in the late 1990s.

Higher inflation expectations, coupled with falling nominal yields – the latter mostly a function of the recent flight to safety – mean that investors can expect a lower real or inflation adjusted return on the 10 year Treasury. Ironically, investors are accepting more expensive Treasuries with lower returns at precisely the moment that supply is surging due to higher deficits. Investors are fleeing to Treasuries as a safe-haven bid in a time of uncertainty, but do Treasuries still offer such a bastion of strength?

While nobody believes the Treasury will fail to meet its obligations, by most standards the credit risk of the United States has deteriorated. At the same time, investors are being asked to accept historically low real returns for owning U.S. Treasuries. With a real yield of less than 1% before taxes, it would appear that both the municipal and corporate bonds currently offer investors better value.