Rabu, 30 Mei 2012

What record-low Treasury yields tell us

As shown in the top chart, 10-yr Treasury yields have never been lower than they are today (1.62% as I write this). Ordinarily, you would expect low Treasury yields to be a sign of low inflation and/or low inflation expectations, but this time around, that's not the case. As the second chart shows, forward-looking inflation expectations, as derived from the pricing of TIPS and Treasuries, are near the upper end of their 15-year historical range and have been rising of late. Forward inflation expectations are slightly higher than the increase in the CPI over the past year (2.3%), and about equal to the average annual increase in the CPI for the past 20 years. In other words, inflation and inflation expectations are alive and well, so the decline in nominal Treasury yields must be symptomatic of something other than inflation. It's also worth noting that real yields on 5-yr TIPS are -1%, and this means that investors are happy to lose 1% of their annual purchasing power in exchange for the privilege of avoiding what they fear will be even bigger losses on just about everything else over the next 5 years. 

The only explanation that fits these facts is that the market is behaving as if economic growth is going to be severely depressed, but without having any negative impact on inflation. That alone is very unusual, since the biggest hit to growth in recent memory (the 2008-9 recession) also produced the lowest inflation expectations ever: 5-yr, 5-yr forward inflation expectations plunged to almost zero in late 2008. This makes sense, however, since the biggest thing happening on the margin is the sovereign debt crisis that is roiling the Eurozone. Europeans are extremely worried about a collapse of the Euro and a return to individual currencies (particularly the Drachma). The collapse of the Euro could bring with it a financial crisis like we saw in the wake of the collapse of Lehman Bros. in 2008, which in turn resulted in a sudden and deep global recession. Plus, it goes without saying that any spin-offs from the Euro are almost certain to result in substantial devaluations, and big devaluations invariably bring with them big increases in inflation.

So the threat of a euro breakup has raised fears of a deep recession accompanied by rising inflation, and with those fears in mind, 10-yr Treasuries yielding less than 2% look like a fabulous safe haven. Europeans are piling into Treasuries since they look like the only lifeboat that's likely to survive. Investors should understand that when the price of safety is extremely high, as it is today, then buying Treasuries in the expectation of making a profit will only work if the future ends up being even more catastrophic than what the market currently expects. By the same logic, buying anything risky in the expectation of making a profit will work as long as the future is less catastrophically bad than is currently expected. In other words, you don't need a robust economy to make money taking risk these days, you just need an economy that avoids disaster. Even a measly 2% real rate of growth in the U.S. economy would be like manna from heaven for investors in risky assets.

So how to explain the fact that, in the face of tremendous uncertainty and expectations of continued inflation, the price of gold (see above chart) has declined by 18% in dollar terms since last September? 

My answer to that rather difficult question is that the market is beginning to realize that the massive central bank easings that we have seen over the past 5 years have not been nearly as inflationary and destructive as the market had feared. At $1900/oz., gold prices had incorporated enormous quantities of fear that have not yet been justified by reality. The future, in other words, has turned out to be much less dire than expected. 

Even after its sharp decline since September, gold has risen by an annualized 14.6% since its low 13 years ago. That's a far cry from Apple's 45% annualized return over the same period, but it beats just about anything else you could hope to have owned. Gold has been priced to very traumatic conditions for quite some time. In real terms, gold today is worth about one-third less that it was at its very brief peak in mid-January 1980, which marked the worst of double-digit inflation fears and a collapsing dollar. But compared to its value at the end of January 1980, gold today is only down 19% in inflation-adjusted terms. In short, gold today is priced at levels that are roughly equivalent to the conditions that prevailed in early 1980, when the world feared recession, a collapsing dollar, and a continuation of double-digit inflation. Conditions might not be all that much better today, but they are almost surely no worse. 

In inflation-adjusted terms and against a broad basket of trade-weighted currencies, the dollar is actually a bit weaker today than it was in early 1980, but inflation and inflation expectations are significantly lower. 

If I had to sum up what all this means, I would say that the evidence of market prices points to a very high level of fear, uncertainty and doubt among global investors. Today's record-low 10-yr Treasury yield is just the latest sign that investors are consumed by fears. When emotions reach such heights, as they did in the early 1980s and in late 2008/early 2009, investors willing to bear risk stand a good chance of being rewarded, provided the future turns out to be less awful than the market expects. 

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