The Highest Real Yields For Treasuries In 15 Years

Treasury notes are looking very attractive due to the deflation of the consumer price index in the first half of the year. A nominal 10-year Treasury note at 3.5% would translate into a real yield of nearly 5.5%. However, if you believe that inflation is around the corner, treasuries may be a very unprofitable investment. James Picerno from The Capital Spectator explains.
The highest real (inflation-adjusted) yields in 15 years for Treasuries are boosting demand, Bloomberg reported at the end of last month.

Halfway through August, there's no reason to think otherwise. The 10-year's yield hasn't changed much in recent weeks, closing yesterday at roughly 3.59%. Meanwhile, inflation, as defined by the consumer price index, appears in no imminent threat of rising.

The July CPI report shows that inflation was flat last month, the Bureau of Labor Statistics tells us today. For the 12 months through July, CPI was negative to the tune of -1.9%, the steepest fall in 60 years.

On the surface, it looks like deflation is roaring. But this bite is worse than it appears. The year-over-year comparisons for CPI are troubling, but it's temporary. Recall that oil prices hit an all-time high in July 2008. The energy driven inflation wave, as it turned out, wasn't set in stone either. But the damage to the inflation numbers was done and that legacy remains intact. As a result, comparing overall prices today with those of a year ago is doomed to reflect sharp price declines.

Meanwhile, energy prices fell sharply after peaking in the summer of 2008, along with prices of virtually every thing else. A repeat performance isn't likely, or so the stabilizing global economy suggests. Indeed, the price of crude seems to have found stability too. The implication: inflation won't be falling on a year-over-year basis when we look at the numbers in the quarters ahead.

Barring a sudden reversal of the stability that seems to be settling into the economy, the year-over-year CPI change is likely to be showing more modest comparisons by the end of this year and through 2010. Why? Because, you may recall, the world fell apart in the second half of 2008, dragging broad price indices down the rat hole in the process. Once we get to December 2009's CPI numbers, however, we're likely to see the case for deflation on a 12-month basis looking a heck of a lot weaker if not evaporating completely, assuming we don't resume an apocalyptic decline, which looks unlikely at this point.

Meantime, adjusting the 10-year Treasury Note by 12-month changes in CPI makes for an alluring chart, as our graph below shows. For July, the 10-year's CPI-adjusted yield was 5.46%, up from September 2008's negative 1.25%.

By the available numbers, buying the 10-year looks like a no-brainer. Prices generally are falling by nearly 2% a year. Meanwhile a nominal 10-year Treasury offers well over 5% real. A great buy, right?

We're suspicious. Unless you're expecting deflation to roar on, which we don't, the real yield in nominal Treasuries looks like a trap. Here's our reasoning. First, only nominal yields are set in stone with nominal Treasuries, which means that real yields for this series of government bonds can and does fluctuate.

For instance, let's say you bought the nominal 10-year Treasury at last night's close of 3.59%. Using the latest CPI report for July, that translates into a real yield of 5.49%. Nice. But imagine a year from now that CPI's running at, say, a positive 2% year-over-year pace, which isn't beyond the pale. Net result: your current real yield of 5.49% evaporates to 1.59%. (Remember, the nominal yield of 3.59% at the purchase date is fixed; only the inflation rate changes.)

As it turns out, a 10-year TIPS currently offers a similar real yield—1.80% as of last night's close. The big difference: the 1.80% real yield for the TIPS is fixed whereas the real yield for nominal Treasuries changes.

The bottom line: unless you're expecting deflation to continue or get worse, the real yield in the nominal 10-year looks dubious. Does that mean you shouldn't own Treasuries? No, since government bonds serve various purposes in a multi-asset class portfolio. But buying solely for the high real yield of the moment is too speculative at this juncture, at least for this observer.

To be fair, no one can predict inflation with any certainty and so a passive investor would own TIPS and nominal Treasuries as a hedge. Otherwise, this is no time to bet the farm on conventional Treasuries. Sitting on huge gains over the past year—indeed, over the past generation, the hour is late for expecting continued success with "risk free" bonds sans inflation protection.

This article has been republished from James Picerno's blog, The Capital Spectator.

How Obama's Stimulus Plan Could Cause A Deeper Recession

Interest rates have been on the rise and Obama's Stimulus Plan that has increased the government deficit may be the culprit. According to Reuters "The U.S. Treasury must sell a record net $2 trillion in new debt in 2009 to fund a $1.8 trillion projected fiscal deficit, resulting from falling tax revenues, an economic stimulus package and sundry bank bailouts." Martin Hutchinson from Money Morning argues why increasing interest rates can be very bad news for the economy.

Could the massive Obama stimulus plan end up hurting the U.S. economy?

It’s long been a worry, and now it’s beginning to seem possible.

The latest housing reports suggest that the recent rapid run-up in 10-year Treasury bond yields may be having an unhealthy effect on the U.S. housing market. That tells me that - although home prices are back to their long-term average in terms of earnings - we may not yet be close to the price bottom.

If that’s true, it’s very bad news. A further substantial decline in housing prices would destabilize the U.S. banking system again, because of all the mortgage debt in it, which would cause a very nasty “second leg” economic downturn. That would have one very ironic further implication: U.S. President Barack Obama’s $787 billion stimulus package - intended to help the U.S. economy push back the recession - would instead have succeeded in pushing it deeper into the mire.

A month ago, it appeared that the housing market might be in the process of bottoming out. The ratio of house prices to average incomes - which peaked at about 4.5 to 1 in 2006 - had fallen 33% from that apex, which brought the ratio close to its long-term average of 3.2 to 1, according to an S&P/Case-Shiller Index report. While interest rates remained low and government-backed home financing was readily available, it appeared the forces pushing up house prices (low interest rates and accessible financing) might soon come into balance and then dominate the forces that push home prices down (an inventory overage).

The jump in interest rates - from 2.07% on the 10-year Treasury bond in December to around 3.65% today - has weakened the case for a stabilization of housing prices. Mortgage rates, which were far below their levels of the last 30 years, have moved back above 5% — even for “conforming” mortgages. Thus the Mortgage Bankers Association index of new mortgage applications was down 15% in the latest week. Meanwhile, new home sales have merely stabilized at very low levels of an annual rate around 350,000 - compared to more than 2.0 million at the peak of the market, while the latest price statistics suggest that price declines continued to be quite rapid in March, and possibly even accelerated slightly.

This interest-rate increase does not currently seem to be caused by expectations of inflation, which has remained around 2% annually, although oil, gold and other commodity prices have ticked up. Instead, it seems to have been caused by the exceptionally high demands being made on the government bond market by the U.S. federal deficit, which is expected to total about 13% of gross domestic product (GDP), or more than $1.8 trillion, this year.

It’s not surprising that such a blip should have occurred this month; federal tax receipts are at their peak in April, as companies and individuals pay their taxes due, so the beginning of May saw a resumption of mammoth U.S. Treasury funding needs after a month’s pause.

If interest rates continue to increase, the effect on the already-weak housing market could be severe, as housing “affordability” would be reduced in a period in which prices were declining and unemployment was rising. That, in turn, could have a self-reinforcing downward effect on prices, as home inventories bloat further, and buyers hold back.

Currently, according to the S&P/Case-Shiller 20-city house price index, prices are down 32% from their peak, but remain 40% above 2000 levels, while consumer prices are only 24% above those of 2000. However, 2000 was not a “bear-market” year; prices had already enjoyed several years of rapid recovery from their early-1990s low. Should rising interest rates cause prices to continue falling to 2000’s level (another 28% decline), then on average every 80% mortgage undertaken since May 2002 (when the index first went above 125% of 2000’s level) would be underwater, having an owed principal amount that exceeds the actual current market value of the house. That would cause a surge in mortgage defaults more severe than any yet seen, extending far into the prime mortgage category - and probably causing the U.S. banking system to implode once again.

The stimulus-package funds, which began flowing in April, may actually induce some GDP growth this quarter. At the very least, the Obama administration infusion should hold the economy to a very minimal decline in GDP.

However, if interest rates keep rising, the effect of further housing-sector weakness and the wobbling banking system would overwhelm any stimulus benefits, and would cause a second “dip” in this recession - one that’s far worse than the first. The stimulus would, in that event, have proved counterproductive, killing the very economic recovery it was supposed to have stimulated.

Rising interest rates will have adverse effects on all countries with large budget deficits, the most notable of which are Britain and Japan. The effects would be harsh enough to actually prevent those countries from recovering from their own recessions.

For investors, the remedy is clear: Look to invest in countries that have produced only modest stimulus packages, and whose budget deficits are currently the smallest. In the invaluable statistical section of The Economist, a number of countries are projected to have budget deficits of less than 3% of GDP in 2009, in spite of their recessions.

At that level, deficits are easy to finance, and do not force up interest rates, so economic recovery should be relatively rapid.

Let’s take a look at some of those countries in question:

Canada:
Budget deficit forecast of 2.5% of GDP. Americans are fond of sneering at Canada for its high public spending and sluggish growth. Well, Canada’s public spending as a percentage of GDP peaked in the early 1990s and since 2000 the country has run budget surpluses. In 2009, Canada is forecast to have public spending lower than the United States, when provinces and states are taken into account, and to continue lower than its arch rival (the United States) for the foreseeable future. I wrote a few weeks ago about investment opportunities in the Canadian energy sector; those opportunities are even more compelling with the continued rise in the oil price to current prices of more than $62 a barrel.

Denmark Finland and Switzerland
Wealthy European countries with healthy budget positions - deficits of 2.5%, 2.6% and 2.0% of GDP, respectively - will recover more quickly than their neighbors, because they have kept their economies in balance.
Brazil
Probably the best of the lot, with a projected budget deficit of only 2% of GDP, inflation of 4.4% and bond yields of 11.8% — meaning it can indulge in a little monetary expansion if it needs to. Brazil will also benefit if inflation returns (as I expect it to), because that will push up the prices of its commodities exports.

So there you have it. Maybe the U.S. bond market and housing market will stabilize, and the American economic recovery will proceed smoothly - nothing is certain. But investments in Canada and Brazil, in particular, will protect you against the possibility that the U.S. situation doesn’t improve.

This article has been reposted from Money Morning. You can view the article on Money Morning's investment news website here.