SIGNALS FROM THE BOND MARKET

As summer comes to its eventual end, the parade of strong economic data continues and major domestic
stock indexes are back to, or even above, their all-time highs set back in January. With all the focus on the good news in both stocks and the economy, it is important to remember that the bond market can offer insights as well. There are some who consider the signals from the bond market to be just as important, or even more so, than those from stocks. It behooves us to pay attention as well. This Market Brief interprets the latest signals from the bond market by considering real, or inflation-adjusted, yields and the slope of the yield curve. Let’s listen.

NOMINAL VS. REAL YIELDS

Many a bond buyer has been heard wishing for the “good ol’ days” of the late 1970s and early 1980s. Back then, yields on 10-year U.S. Treasury Notes (US10) ranged mostly between 10-12%, but did get as high as 15%. Yields that high are practically unheard of in today’s domestic markets, even in high yield bonds. However, it has also been said that “it’s not what you make, but what you keep” and for bond investors what you “keep” is your yield, less inflation. The chart on the top of page three (left) shows US10 yields, inflation and a real yield equal to the US10 yield less inflation. During that same period mentioned above, real yields were as low as -4% and as high as 8%. Beginning in the mid 1980s and continuing to the present, real yields have fallen from about 9% to nearly zero today, with periods of negative yields emerging briefly in 2008, 2011, and 2012. Many investors consider the last 40 years of data and broadly infer that real yields on US10s range from 2-4%. Despite that generalization, bonds have more to say.

Why would real bond yields vary so greatly over time? And why would they ever be negative? Economic growth and inflation are the answer. If bond investors are indeed a cautious bunch, they would own fewer bonds when inflation expectations are rising (their selling pushes rates higher) because future coupon payments will be worth less after inflation. Conversely, they would own more when inflation expectations are falling (their buying pushes rates down). Since bond prices and yields adjust at differing speeds compared to growth and inflation expectations, real yields in the lower end, or below the inferred 2-4% range, could indicate bondholders believe growth and/or inflation rates may be low or decline in the future. When yields are at the high end or above this range, bondholders likely believe growth and inflation may remain elevated or accelerate. The message from today’s near-zero real bond yields could be that economic growth and inflation might not have much room to expand further.

Read the full September Market Review.

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