Bond Markets Sending a Mixed Message?

Includes: IEF, VXX
by: Investment Pancake

Getting 3% on my money for ten years' worth of risk? You have got t be kidding me. Evidently, the bond market is not, because that's what a ten year Treasury has to offer today. This may strike one as a rather paltry nominal return, which has lead market commentators to draw one of two conclusions.

Possibility number one: the US is heading into a deflationary spiral. As prices for assets and goods drop in the future, the real value of a future dollar grows correspondingly. So, if the bond market expects deflation at a rate of 3%, for example, for the next ten years, then that nominal 3% yield on a ten year US Treasury is actually a real 6% yield. Which is a perfectly rational return for investors to chase.

Possibility number two: US Treasuries are in a bubble, and the bond market has simply become irrational. This is another way of saying that investors are so wildly risk-averse, they will actually pay to not take risk. Which is another way of saying they are irrationally pricing risk, or the incorrectly-perceived lack thereof.

So, which one is it? Deflation or irrational risk aversion? Some indicators suggest an answer to that question. For instance, at this point, the Chicago Volatility Index (VIX) is elevated, but nowhere close to the extremes we saw in March of 2009. So, if future expected volatility is a measure of fear, then investors are not all that fearful yet. Another indication that we are nowhere near extreme risk aversion is that the TED spread remains fairly normal - meaning, banks are willing to lend to one another. Banks don't do that when they are highly risk averse, and so the story of extreme risk aversion isn't something that the TED spread bears out at the moment. Yet another hint may lie in the PE ratios for some equities indexes. The ten-year PE ratio for the S&P 500 (NYSEARCA:SPY) remains at a relatively high 20, meaning, an investor would have to wait twenty years to garner sufficient earnings to pay for his investment. That should strike you as a very healthy risk appetite - and indeed, a historically elevated one at that.

The extreme risk-aversion, bubble in the Treasury market theme isn't completely born out by some of the best risk-appetite indicators available to investors. So, if we are not in the throws of an orgy of risk-aversion, then the only way to explain today's yields is simply this: the bond market is pricing in future deflation.

Could it be wrong? Obviously, yes, because the future is unknown. But some mechanisms, like capital markets, can be far more adept at predicting future outcomes than even the very smartest individual investors. You should ignore what the capital markets are saying at your peril.

Disclosure: Author is long US Treasuries