This is one of my favorite topics as you can probably guess.
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This is a chart showing how we would have done buying the 10-year note and holding until maturity. It ends in November 1997 because notes purchased then would be maturing right now (and we can use the last ten years of inflation data to see how we would have done).
I've showed similar charts in the past. This time I have a few more charts to think about.
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This is how we would have done had we simply gone shopping based on the nominal yield we were offered. The higher the nominal yield, the better we would have done in general. Note that the current yield on the 10-year treasury note is just a hair over 4%. That does not inspire confidence that it will be yielding a great deal of profits. It could of course, should we experience a severe deflation. I'd just be wary of betting on that outcome personally.
Now let's talk about how the above chart is actually two entirely different eras.
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This shows an era when interest rates and inflation started off very low and generally rose over time. Note that for roughly two decades the 10 year treasury note was a relatively bad investment.
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This shows an era when interest rates and inflation started off very high and generally fell over time. Note that for roughly two decades the 10 year treasury note was a relatively good investment.
The 10-year treasury is currently yielding just over 4%. That doesn't look great on either era's chart. This is one reason why I'm willing to predict the death of real yields. I might be wrong, but I think it is going to be very difficult to actually make money in the future.
Let's do some quick math using the treasury market's own data to predict the 10-year treasury note's expected 10 year profits as of 12/14/07.
The 10 year note yields 4.24%.
The 10 year TIPS yields 1.90% (plus inflation as time goes on).
That puts the expected inflation at 2.34% per year. If you earn 4.24% but pay 35% taxes, that's an after tax growth of 2.756%. You will lose 2.34% to inflation though. After 10 years you will have earned 4.1% in total real after tax profits. That's pretty much in line with the extrapolated red trend line in the bottom chart. That's the good era's chart though. If we slide into the bad era's chart, oh oh. We could be looking at some serious losses.
This is not investment advice. The deflationists could be right. I'm just suggesting that they've got some serious kahonies to be that sure they are right.
I also want to point out how we will probably react if inflation and interest rates rise. We probably won't be thinking in terms of positive real yields. The aftermath of the 1970s ended up providing real yields simply because inflation fell. Inflation is not guaranteed to fall. It might stay uncomfortably high for longer than any of us could possibly imagine. Past performance is no guarantee of future results, right? Further, if inflation does fall that doesn't necessarily mean we will know it in advance. I suspect strongly that low real yield expectations, once established, would therefore remain low.
I also want to add that the 10 year TIPS isn't going to perform any better if the market truly understands the next 10 years worth of inflation with its prediction. However, if (big if) the market should be wrong and both inflation and interest rates do rise, TIPS would be vastly superior to nominal 10 year notes (as TIPS are tied to the inflation rate).
As owners of TIPS we should want to be wrong. We still want low inflation (if only so we pay less taxes). It is kind of like having homeowner's insurance. Just because you have it doesn't mean you pray for your house to burn. Those holding nominal treasuries would outperform us, but we'd be doing okay. We therefore would relish being wrong. We'd love to be wrong on almost everything in fact. It would be so much easier to protect ourselves. Inflation hurts everyone.
Source Data:
FRB: Selected Interest RatesSt. Louis Fed: Consumer Price Index for All Urban Consumers: All Items