International investors still flock to the United States Treasury bond market to keep their funds in a “safe place.” As a consequence of this, interest rate relationships continue to be distorted. Since early August 2011, the yield on the 10-year U.S. Treasury bond has fluctuated somewhere around the 2.00 percent level.
These declines occurred during the fall events that surrounded the fiscal problems in Greece. The yields have remained at these low levels through the Greek restructuring and into the recurring concerns over the budget fights in Spain and Italy.
The dramatic drop in the Treasury yield can be seen in the accompanying chart. The 10-year Treasury was trading at or above 3.00 percent up until early August 2011. Then the drop occurred. And, the yield has basically moved around 2.00 percent since then.
(Click charts to enlarge)
The interesting thing to me in this shift is what has happened to the yield on U.S. Treasury Inflation-indexed securities. They went negative in early August and, after bouncing around for a couple of months, dropped into negative territory again in early November and have stayed there since. This can be seen in the chart below. Yesterday the 10-year Treasury inflation indexed bond closed to yield a negative 0.31 percent.
The Treasury inflation indexed bond, since it was created, has served as a proxy for the “real” rate of interest. It has varied a great deal more than one would like an “expected” real rate of interest to vary, but it, nonetheless has provided a benchmark that can be useful in analyzing what is going on in financial markets.
Theoretically, the “real” rate of interest should be equal to the long-run rate of growth of the economy. Over the past 50 years, a “rough” workable estimate for the real rate of interest was 3.0 percent, which was close to the compound rate of growth of real GDP from 1960 to the 2000s.
One could then get a “rough” estimate of the inflationary expectations built into interest rates by subtracting this estimate of the real rate of interest from a nominal rate of interest, the yield on the 10-year U.S. Treasury bond. Then one could compare the yield on the Treasury inflation indexed bond with these other measures in an attempt to understand what was currently going on.
In the current situation, one finds it hard to support any proxy estimate for the “real” rate of interest. The old estimates derived from the real growth rate of GDP seem useless given the current environment. And, the combined effects of the Federal Reserve’s quantitative easing and the “flight to quality” of the international investor have distorted market relationships. That is, the past is not a good guide to the present interest rate relationships.
Rather than starting with an estimate of the “real” rate of interest, it seems that the place where one should begin is the nominal yield, the yield on the 10-year Treasury security. Yesterday, the 10-year Treasury security closed with a yield of just about 2.00 percent. The yield on the 10-year Treasury inflation indexed security closed at about a negative 0.30 percent.
The difference between the two, about 230 basis points can be used as an estimate of the inflationary expectations of the market. The year-over-year rate of increase in the price deflator for GDP was slightly about 210 basis points. Thus, one could argue that the relationship between the yield on the 10-year Treasury security and the yield on the 10-year Treasury inflation indexed security…the proxy for inflationary expectations…was roughly in line with the actual inflation going on in the economy.
One could then argue that the yield on the 10-year Treasury inflation indexed securities is negative because the flight to quality, along with the quantitative easing on the part of the Fed, has resulted in the yield of the 10-year Treasury reaching such a low level. That is, the Fed’s actions along with the European financial crisis have distorted interest rate relationships to the point where we actually have some market interest rates that are negative. The inflation-indexed security bears a negative yield because investors still must consider how actual inflation will impact the nominal returns they receive on their bonds. Given the inflation that is expected by the market and given the current level of yields on “risk free” securities, the “real” yield in the market place can be no where else but in negative territory.
Here, then, is a way to interpret the extent of the financial upheaval going on in the world. If the yields on the Treasury’s inflation indexed bonds remain negative or extraordinarily low, then one can assume that the risk-avoidance going on in the world is still quite high.