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Real bond yields [ClearOnMoney]
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Commentary

Real bond yields

7 Sep 2011 by Jim Fickett.

Rational bond investment requires a guess on inflation. The only hard number that is useful is past inflation. Beyond this, one has to guess what the government will do.

To invest rationally in bonds, one needs to think about real (inflation-adjusted) yields. After all, a 2% yield might look pretty good in an era of deflation, while it would look terrible if inflation were running at 3%.

In actuality, total real return will not be known until the bond matures and we can see what inflation has done to the value of both interest and principal over the life of the bond. Still, in order to assess investment opportunities, we need to make a best guess on what the real yield will be, and hence a best guess as to what inflation will be. The contention of this post is that the best one can do, in guessing future inflation, is start with the current inflation rate and adjust from there based on one's political understanding.

How far off is current inflation alone as a predictor? In the following graph, the blue line is inflation over the previous year. The red line is inflation over the next 10 years, annualized. Clearly (1) there is some predictive power, but (2) it is only moderately helpful. Past inflation can be either far lower (e.g. 1972) or far higher (e.g. 1980) than future inflation.

Since TIPS provide a real yield directly, on top of principal that is adjusted for inflation, economists like to take the so-called breakeven rate – the difference between a nominal Treasury bond yield and the TIPS yield for the same maturity – as an indication of future inflation. This is nice in theory but, for investors, it is actually not useful. TIPS do not have a long enough history that we can check the predictive power of the breakeven rate directly, but it is easy to see that the bond market in general does not, in fact, anticipate inflation. The green line in the above graph shows the yield on the 10-year Treasury bond, less 2% (assuming that investors are looking for some real return in addition to inflation). The green line is much more highly correlated with the blue line than the red line; that is, nominal Treasury yields reflect past inflation and are not good at anticipating future inflation.

Since markets are not good at anticipating inflation, the most useful hard number available is simply the recent (retrospective) inflation rate. Beyond this one is left with trying to understand fundamentals. In the early 1970s, a large increase in the money supply, wage and price controls (which never work for long), and the need to end the gold standard, were all reasons to be less than optimistic about inflation. And in 1979/1980, one might have listened to what Paul Volcker was saying, and decided that the worst was over.