What’s Driving the Bond Rally?

Treasury bond yields have plunged recently which may seem odd since long-term Treasuries were famously downgraded by Standard & Poor’s. So what’s driving the bond rally?

We can never say for certain but we can shine a light on some of the usual suspects underpinning the bond market.

Here’s a look at the yield on the 10-year Treasury bond (blue) along with the 10-year TIPs (or Treasury Inflation-Protected security in red).

The 10-year TIPs yield recently turned slightly negative which means that investors are so frightened that they’re willing to forgo all of their real profits just for the safety of the Treasury market. Or rather, the supposed safety of the Treasury market. (In fact, it may even be worse for bond holders since the CPI probably understates inflation.)

The key for us to watch is the spread between the two lines which represents the inflation premium. Since both lines have plunged in near tandem, this means the market isn’t expecting inflation to either ramp up or slow down. The inflation premium is currently around 2.2% and that’s been pretty stable (between 2.2% and 2.6% for the last several months). Instead, the plunge in yields is almost entirely due to lower real rates.

That’s mostly the result of a worsening economic outlook and a desire from investors to hold anything liquid.

Now here’s the chart which I think is particularly fascinating and should be getting a lot more attention. It shows how the 10-year inflation premium (in red, meaning the difference between the two lines above) has closely matched the S&P 500 (blue) over the last three-and-a-half years.

This is a chart Lord Keynes (and Paul Krugman) might enjoy because it seems that the market has rallied as inflation expectations rose. This is the exact opposite of what happened during the 1970s when inflation slowly ground down stock valuations. I should add the proper caveat that correlation doesn’t mean causation. The higher inflation expectations, of course, might be a response to higher share prices — or the correlation might be entirely illusionary.

But another interesting angle is that the recent equity sell-off marked the first major departure between these lines in quite some time. This lends evidence to the idea that the lower real bond yields are the result of a dreary economic outlook.

The lines have just recently gotten together again. For now, the stock market may be asking for some more inflation. I recently ran the numbers from Professor Robert Shiller’s website to see how stocks perform relative to different inflation rates. The stock market clearly hates inflation, but historically, the hatred doesn’t kick in until inflation hits 5.3%. We’re still a long way from there.

The sad story might be that the Fed’s only clear-cut triumph of the last 30 years (defeating inflation) might be exactly what we don’t need right now.

Posted by on August 16th, 2011 at 4:17 pm


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