Rabu, 16 Januari 2013

Why Treasury yields are so low

December's Consumer Price Index was unchanged, as expected. It rose 1.74% last year, which, as the chart above shows, is somewhat less than its annualized rate of 2.4% over the past 10 years. Meanwhile, the core CPI rose 1.9% last year. It's hard to find anything out of the ordinary in the inflation stats these days.

What does stand out, however, is the unusually low level of T-bond yields relative to inflation. The chart above is structured to show that 30-yr bond yields over very long periods have averaged about 2.5% more than core inflation. If that long-term average condition were to prevail today, 30-yr T-bond yields would be trading around 4.5%; instead they are 3.0%. Bond yields were arguably fairly valued for much of the decade of the 2000's (as the two lines frequently overlapped). But in the past year or so, bond yields have fallen while inflation has risen, and 30-yr bond yields today are only slightly higher than the average inflation rate over the past decade. Thus, bonds arguably are richly valued today.

It's commonly thought that bond yields are low because the Fed is buying a lot of them in conjunction with its Quantitative Easing program. But the Fed todays owns only $1.7 trillion worth of Treasuries, or 14.4% of all the Treasuries held by the public. The public, in other words, owns $9.9 trillion of Treasuries, which is almost seven times more than the Fed owns. I find it hard to believe that the Fed's ownership of only a fraction of the outstanding Treasuries, and its willingness to buy another small piece over the course of this year, is enough to significantly distort the pricing of all of those securities. Common sense tells us that the price of Treasuries is determined by the public's willingness to hold the outstanding stock of Treasuries, not by anyone's willingness to purchase the new Treasuries sold on the margin.

What is more plausible is that the Fed's repeated promises to keep short-term interest rates low for an extended period, conditioned on the economy remaining relatively weak and with a surfeit of unused capacity, are convincing enough to encourage the market to bid up the price of Treasury notes and bonds beyond a level consistent with the prevailing inflation rate.

It's a readily observable fact that the economy has managed only a tepid recovery from its worst recession in modern memory, and it's clear that the burdens of government—spending, taxation, and regulatory—are greater today than they have ever been. It's not hard, therefore, to conclude that the economy is unlikely to grow by enough in the next few years to cause the Fed to accelerate its timetable for higher interest rates. This, I would argue, coupled with the market's generally high level of risk aversion (which can be found in $1700 gold, negative real yields on TIPS, the relatively low level of equity PEs, the 70% growth in bank savings deposits since late 2008, and the huge outflows from equity mutual funds in recent years), offers a much more robust explanation for why Treasury yields are so low today. The market is scared, and confidence in the economy's ability to generate stronger growth is very weak. The market is thus quite willing to pay a premium for the safety and security of Treasuries.

Low yields on Treasuries are thus an excellent indicator of how bearish the market is, regardless of what the surveys might say.

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