The “bond bubble” discussion in the mainstream media has become deafening lately. Some of the commentary has been thoughtful and interesting, but not all of it. Much of the bubble-watch has focused on asset flows into fixed income funds, the total return of Treasuries over the last 10 years, and the theoretical possibility of a bubble in an asset class that guarantees return of principal.
Asset class inflows or high total returns can be symptomatic of a bubble, but a true bubble must be characterized by extreme overvaluation. Beyond pointing to a nominally low yield, the discussion of Treasury valuation has been lacking. Certainly the Siegel/Schwartz WSJ editorial comparing 10-year TIPS to tech stocks valued at 100x earnings is not a realistic comparison. Treasuries aren’t valued on a P/E basis; Investors buy Treasuries to earn risk-free income. In the short run, Treasury yields are driven by the usual suspects: fear and greed. But in the long run, the biggest influence on yields is anticipated inflation. Investors demand a certain return, after inflation, for risk-free investments. The chart below plots the 10-year Treasury yield against the year-over-year change in core inflation.
When “valuing” the 10-year Treasury, your estimate of future inflation seems to be the most salient input. The problem is that nobody knows what inflation will be like for the next 10 years, so we have to guess. Behavioral economics defines the overweighting of recent experience as the “recency effect.” During the late 1960s and 1970s, yields on the 10-year rose but didn’t quite keep up with the rising level of inflation, as investors had grown accustomed to the preceding period of low inflation. Throughout much of the 1980s, investors were reluctant to push the yield on the 10-year yield down in line with inflation, for fear of its eminent return. The mispricing during this period is more evident when looking at the spread between the 10-year and core inflation.
The mispricing that happened from the late 1960s throughout much of the 1980s was due to a volatile period where there was much uncertainty about the future rate of inflation. The average spread between the 10-year and core inflation in the chart above is 2.66% (it falls to 2.63% if you use the CPI-All Items index…essentially the same). The data series of the constant maturity 10-year from the Federal Reserve is admittedly small (it only goes back to 1953), but back-checking it using Professor Robert Shiller’s much longer data set yields an average spread of 2.42% on comparable data going back to 1871. The current 2.03% spread is certainly not out of the norm for this data series, unlike the valuation of tech stocks in 1999 which was many standard deviations away from normal.
When viewed in this context, the 10-year doesn’t look like a bubble. It looks like market participants are expressing an opinion about where inflation is going. And based on the historical relationship between Treasury yields and inflation, they aren’t doing it in an extreme way.