Halfway through August, there’s no reason to think otherwise. The 10-year’s yield hasn’t changed much in recent weeks, closing yesterday at roughly 3.59%. Meanwhile, inflation, as defined by the consumer price index, appears in no imminent threat of rising.
The July CPI report shows that inflation was flat last month, the Bureau of Labor Statistics tells us today. For the 12 months through July, CPI was negative to the tune of -1.9%, the steepest fall in 60 years.
On the surface, it looks like deflation is roaring. But this bite is worse than it appears. The year-over-year comparisons for CPI are troubling, but it’s temporary. Recall that oil prices hit an all-time high in July 2008. The energy driven inflation wave, as it turned out, wasn’t set in stone either. But the damage to the inflation numbers was done and that legacy remains intact. As a result, comparing overall prices today with those of a year ago is doomed to reflect sharp price declines.
Meanwhile, energy prices fell sharply after peaking in the summer of 2008, along with prices of virtually every thing else. A repeat performance isn’t likely, or so the stabilizing global economy suggests. Indeed, the price of crude seems to have found stability too. The implication: inflation won’t be falling on a year-over-year basis when we look at the numbers in the quarters ahead.
Barring a sudden reversal of the stability that seems to be settling into the economy, the year-over-year CPI change is likely to be showing more modest comparisons by the end of this year and through 2010. Why? Because, you may recall, the world fell apart in the second half of 2008, dragging broad price indices down the rat hole in the process. Once we get to December 2009’s CPI numbers, however, we’re likely to see the case for deflation on a 12-month basis looking a heck of a lot weaker if not evaporating completely, assuming we don’t resume an apocalyptic decline, which looks unlikely at this point.
Meantime, adjusting the 10-year Treasury Note by 12-month changes in CPI makes for an alluring chart, as our graph below shows. For July, the 10-year’s CPI-adjusted yield was 5.46%, up from September 2008’s negative 1.25%.
By the available numbers, buying the 10-year looks like a no-brainer. Prices generally are falling by nearly 2% a year. Meanwhile a nominal 10-year Treasury offers well over 5% real. A great buy, right?
We’re suspicious. Unless you’re expecting deflation to roar on, which we don’t, the real yield in nominal Treasuries looks like a trap. Here’s our reasoning. First, only nominal yields are set in stone with nominal Treasuries, which means that real yields for this series of government bonds can and does fluctuate.
For instance, let’s say you bought the nominal 10-year Treasury at last night’s close of 3.59%. Using the latest CPI report for July, that translates into a real yield of 5.49%. Nice. But imagine a year from now that CPI’s running at, say, a positive 2% year-over-year pace, which isn’t beyond the pale. Net result: your current real yield of 5.49% evaporates to 1.59%. (Remember, the nominal yield of 3.59% at the purchase date is fixed; only the inflation rate changes.)
As it turns out, a 10-year TIPS currently offers a similar real yield—1.80% as of last night’s close. The big difference: the 1.80% real yield for the TIPS is fixed whereas the real yield for nominal Treasuries changes.
The bottom line: unless you’re expecting deflation to continue or get worse, the real yield in the nominal 10-year looks dubious. Does that mean you shouldn’t own Treasuries? No, since government bonds serve various purposes in a multi-asset class portfolio. But buying solely for the high real yield of the moment is too speculative at this juncture, at least for this observer.
To be fair, no one can predict inflation with any certainty and so a passive investor would own TIPS and nominal Treasuries as a hedge. Otherwise, this is no time to bet the farm on conventional Treasuries. Sitting on huge gains over the past year—indeed, over the past generation, the hour is late for expecting continued success with “risk free” bonds sans inflation protection.