Monday, November 7, 2011

Clues in the Yield Curve

If you told me what the 5-year nominal treasury yield is then I would use the following chart to guess what the 10-year nominal treasury yield is. That said, things will get a bit muddy if we keep trying to fall off of the chart.

Click to enlarge.

For example, if you were to tell me that the 5-year treasury yield was 0.0% then I would guess that the 10-year treasury yield would be 0.78% (see the formula in bright red).

Or would I?

Click to enlarge.

Using only the nominal treasury data from 2003 to today, I might be tempted to guess 1.95% instead (see the formula in bright red).

Let's continue the guessing games. Using similar short-term data on TIPS (as seen in the chart above), if you told me that the real yield of the 5-year TIPS is 0.0% then I might guess that the 10-year TIPS would be 1.0% (see the formula in dark red).

Said mostly tongue-in-cheek, when can we expect to return to such a prosperous era? Can't you just picture a world where a guaranteed 0.0% pre-tax 5-year return on capital was once again possible?

Now let's turn our attention to the spreads directly.

Click to enlarge.

As seen in the chart, the spread between the 10-year treasury and the 5-year treasury is currently extremely high and was recently in record setting territory. Banks love a large spread. Borrow short, lend long. Will it continue? If it does not continue then how will it change?

1. Short-term rates could rise. That's not going to happen any time soon. Bernanke has all but promised that.
2. Long-term rates could fall as investors eventually capitulate and accept lower yields. Think of it as an
infection on spreads that spreads. Pun intended. It's a fun game! Think Japan!

For what it is worth, I bet big on the latter earlier this year. No complaints so far.

Here's a closer look at recent years. I've included the TIPS spread as well.

Click to enlarge.

That huge downward spike in the TIPS spread was due to the deflationary event in 2008. It could happen again (perhaps this very Christmas season). If so, I plan to ride it out again.

Please note the nearly perfectly anchored inflation expectations of the red and black lines heading into the deflationary event of 2008. The lines do not directly represent inflation expectations but consider this. If the difference between 5-year TIPS and 10-year TIPS is identical to the difference between 5-year nominal treasuries and 10-year treasuries then none of the extra yield in longer term maturities was probably due to inflation expectations. None of it. It must therefore be other things, such as opportunity cost and liquidity risks.

This chart also proves that the bond market is not omniscient. It was completely and utterly blindsided by deflation, much like the stock market was. Trust it to predict the future inflation rate at your own peril.

Disclosure: The vast majority of my nest egg sits in TIPS and I-Bond ladders bought directly from the government, held to maturity, and with a decidedly long-term bias (to hopefully meet my long-term needs).

Source Data:
St. Louis Fed: 5-Year Treasury
St. Louis Fed: 10-Year Treasury
St. Louis Fed: 5-Year TIPS
St. Louis Fed: 10-Year TIPS
U.S. Treasury: Yield Curve


Stagflationary Mark said...

Bonus Thought of the Day

Could someone explain to me how the Euro isn't a Structured Investment Currency (SIC)?

This is why I bring it up.

I have no real desire to invest in any individual European country's currency and yet for the past decade I've been told to invest in Euros.

There's something "SIC" about this and in my opinion it smells of rotting fish.

Put another way, the mechanism holding the euro up better not just be faith.

I'm neither long nor shorting it. I'm mostly indifferent. I have the same reaction to the grass on the other side of the fence. It may be greener but if it is it might just indicate the location of a septic tank. At least I know MY grass is located over one. (I tend to stick with the known evil apparently.)

Mr Slippery said...

Re: yields
I think they reflect the real potential for economic growth, e.g. very little.

Re: euro
It was flawed from the start and a lot of economists pointed to the exact problem they are experiencing now. But political hubris takes precedence until abject failure arrives. We are almost there. The only possible solution to Italy is unreserved euro printing by the ECB to buy all their crap paper. That creates all kinds of new problems. Because money printing is easier that facing reality, I expect the ECB to relent. Another reason I am holding gold and increased my stake today.

Re: grass
I love the septic analogy with greener grass. My grass is not in good shape, but I plan to turn it over to a professional in January after 5 years of abuse at my hands.

Stagflationary Mark said...

Mr Slippery,

My grass is not in good shape, but I plan to turn it over to a professional in January after 5 years of abuse at my hands.

Is it really abuse? I like to think of it as simply letting nature take its course (that, and I'm "naturally" lazy, lol).

The "professional" should have your lawn addicted to the fertilizer "crack" that only he/she can provide in no time! Be especially wary if the first "treatment" is free! ;)

Homeowner's Guide to Protecting Frogs - Lawn & Garden Care

Homeowners use up to 10 times more chemical pesticides per acre on their lawns than farmers use on crops, and they spend more per acre, on average, to maintain their lawns than farmers spend per agricultural acre.