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What are investors in the bond markets trying to tell us? To me, we must give some kind of interpretation to where current yields are in order to get some idea about where financial markets believe that the economy is going.

Historically, one could take an estimate for the expected real rate of interest and add to this one’s expectation for inflation and come up with a projection for what the nominal rate of interest on United States Treasury should be.

In today’s environment this is problematic. In the past a good proxy for the expected real rate of interest was the expected long-term growth rate of the economy. (Equating the expected real rate of interest with the expected long-term growth rate of the economy has the backing of the accepted economic growth theory and has worked on a practical basis.)

Whereas in the past one could estimate the expected real rate of interest at around 3.00 percent since the expected long-run rate of growth of the economy could be around this number.

Being a little more conservative let’s say that the expected real rate of growth of the economy in the near term will be around 2.25 percent. Given the rule presented above this means that we could expect that the real rate of interest in the economy should be around 2.25 percent.

Now, the current year-over-year rate of increase in the GDP implicit price deflator is 2.1 percent. Again, to be conservative, let’s assume that our expected rate of inflation is just 2.0 percent.

This would mean that our estimate for the yield on the 10-year U.S. Treasury bond would be 4.25 percent even given our very conservative estimates of the real rate of interest and inflationary expectations.

This forecast is problematic because the current yield on the 10-year U.S. Treasury bond is around 2.00 percent.

The problem that we are dealing with at the present time is that the United States is experiencing an inflow of funds from the rest of the world due to a “flight to quality” coming from the continent of Europe. In this “flight to quality” investors are not looking at earning a sufficient amount of return to earn themselves an inflation protected real rate of interest. These investors are looking primarily for a “safe haven” in which to place their funds and earn something more than they would earn keeping their funds in cash or very short-term securities.

This “flight-to-quality” has driven the yield on the 10-year U.S. Treasury security to around 2.00 percent. This “flight” is the dominating force in the bond market these days.

This “flight” is even dominating whatever the Federal Reserve is doing these days. The interpretation here is that the supply of funds coming into the U.S. market is keeping these interest rates so low allowing the Fed to do next to nothing in keeping U.S. interest rates so low. This, of course, is taking some of the pressure off Fed Chairman Ben Bernanke.

Bond holders, however, want to be protected from the deterioration of the real value of their bonds so they are still asking for protection against the inflation they expect to face in the future. That is why the yield on 10-year inflation-protected Treasury issues (TIPS) have been paying a negative yield. This negative yield is around 0.30 percent.

Thus, if one subtracts the yield on TIPS from the yield on the 10-year issue from the yield on the 10-year Treasury bond, one comes up with the market’s current estimate for future inflation. At this time expected inflation is around 2.30 percent, a little above the current rate of inflation cited above.

Note that the yield on TIPS became negative in early August 2011, when the European sovereign debt crisis picked up once again specifically relating to the events in Greece. The concerns over Europe continue with the emphasis now shifted to Spain.

In terms of the future, I would argue that the negative yield on TIPS bonds will not become positive again until the European situations eases enough so that funds will start returning to “riskier” debt in Spain, and Portugal, and Greece, and Italy. As these funds begin to flow out of the U.S. Treasury market, yields will begin to rise and historical relationships will return.

(click to enlarge)
(Click to enlarge)

What I am saying here is that if TIPS rise to around 1.00 percent, the level of earlier 2011 as seen in the accompanying chart, and inflationary expectations remain at even 2.00 percent, the yield on the 10-year Treasury issue should rise to at least 3.00 percent.

If the economy continues to grow at a rate in excess of 2.00 percent and inflationary expectations remain at the 2.00 percent level, the yield on the 10-year Treasury issue should rise to at least 4.00 percent.

The European debt crisis is having a major impact on U.S. bond markets and yield relationships and will continue to do so until European officials really resolve their fiscal problems. Thus, look for what happens to the yield on TIPS in the near future. That will provide information on what the financial markets think about European prospects.

Given this scenario, the next pressure point for the Federal Reserve will occur when the Europeans do resolve their financial issues. Then the Federal Reserve will be faced with having to deal with rising interest rates and this will make its life just that much harder.

Source: What Are The Bond Markets Trying To Tell Us?