Marketwatchers are predicting lower and lower yields for the T-note. Bank of America now forecasts 1.30% and DB sees 1.25%.
Real returns (yield minus CPI) for the 10-year have been negative since April 2011.
In a normal environment, the spread between 10-year notes and CPI is positive — return exceeds inflation but in the current environment returns are negative when inflation is factored in.
It’s difficult to explain why anyone would buy Treasuries at these levels, let alone forecast lower yields yet but two reasons spring to mind.
- Trading on price, not yield. Speculators, not investors, are driving the market. They don’t intend to hold to maturity but rather to sell to the Fed in QE3 or some other investor that must hold govt bonds (like insurance companies)
- Deflation expectations. You don’t hear much talk about this but with the CRB commodity index down 12.7% in May and 17% since the February highs, it’s time to start the discussion.
Comparing CPI to 10-year yields, we can see that the 2008 episode of negative real returns was followed by a CPI reading as low as -2.1% y/y.
The difference then was that nominal yields remained well-above 2% and often above 3% — above the Fed’s 2% target, so over the long-run your returns would be positive. This time then nominal yield at 1.5%.
This could be implying that the Fed doesn’t have the credibility (or perhaps the political power) to defend its 2% target. That’s realistic in a commodity-deflation scenario and/or a sharp drop in economic activity (a crisis or the ‘fiscal cliff’).
A deflationary economy that the Fed doesn’t have the power to stop is a frightful scenario but the Japanese experience shows that it’s currency-positive. The 10-year yield may be making a case for buying US dollars.
