Reading The Treasury Tea Leaves

Apr. 13, 2012 5:04 PM ETTMF, TMV, DTYL, DTYS25 Comments
Calafia Beach Pundit profile picture
Calafia Beach Pundit

The purpose of these two charts is to show that the bond market is not always right when it comes to inflation. From a long-term perspective (e.g., 50 years), the yield on risk-free Treasuries of 10 years' maturity or more has averaged about 2.5 percentage points above inflation. This is rational, because while Treasuries are default-free, tying one's money up for a multi-year period puts the investor at risk of receiving a return that fails to maintain the purchasing power of his funds. So moving out the Treasury yield curve should give an investor some modest expected real return, and 2.5% sounds about right. But over shorter time frames, it doesn't always work this way.

The top chart compares the yield on 30-year Treasuries to the Core CPI, and the bottom chart compares the same yield to the PCE deflator, which is a broader and somewhat more volatile measure of inflation than is the core CPI. Both charts are set up to show that when yields and inflation converge, that is equivalent to a 2.5 percentage point expected real rate of return. In other words, when the two lines are on top of each other, bonds are arguably fairly valued.

But bonds are not always fairly valued, as should be obvious. Bond yields were way below where they should have been in the 1970s, mainly because investors were slow to raise their expectations for inflation as actual inflation exceeded expectations. By the early 1980s, however, everyone knew inflation was a big problem and so the yield on long bonds rose to levels that exceeded inflation by a substantial margin. (I was lucky enough to realize this at the time, and bought 30-year Treasury strips yielding over 11% for my IRA account which I sold 10 years later for a 300% profit.)

This article was written by

Calafia Beach Pundit profile picture
Scott Grannis was Chief Economist from 1989 to 2007 at Western Asset Management Company, a Pasadena-based manager of fixed-income funds for institutional investors around the globe. He was a member of Western's Investment Strategy Committee, was responsible for developing the firm's domestic and international outlook, and provided consultation and advice on investment and asset allocation strategies to CFOs, Treasurers, and pension fund managers. He specialized in analysis of Federal Reserve policy and interest rate forecasting, and spearheaded the firm's research into Treasury Inflation Protected Securities (TIPS). Prior to joining Western Asset, he was Senior Economist at the Claremont Economics Institute, an economic forecasting and consulting service headed by John Rutledge, from 1980 to 1986. From 1986 to 1989, he was Principal at Leland O'Brien Rubinstein Associates, a financial services firm that specialized in sophisticated hedging strategies for institutional investors. Visit his blog: Calafia Beach Pundit (

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