Dissecting the Yield Curve, Looking for Inflation – Yup, There It Is

Friday, January 15, 2010

01-15 1028616_arrow_rgb_1-200The recent bond yield increase is raising the question of inflation. Is it the cause? Yesterday, I included inflation with three other factors: economic growth, large bond supply and the effect of short-term rates rising. Because inflation can have serious negative effects, it is the item causing concern. Is there a way to get at inflation expectations? Yes, by tearing apart the yield curve, as I describe below…

At first blush, today’s yields, other than rising, don’t look worrisome. For example, the 10-year US Treasury has gone from a December 1 yield of 3.2% to 3.74% at yesterday’s close. However, that 3.74% doesn’t give us the information we need. For that, we have to make two adjustments.

First, we must remove the effect of interest payments. Buying that 10-year bond doesn’t require leaving all the money invested for the entire period. Regular interest payments mean we are getting some of our money back earlier, thereby scattering the inflation risk over the years.

We can remove this effect by looking at “stripped” US Treasury securities. These are bonds that make one payment only – at maturity. So, for the pure 10-year yield, we look at the stripped issue maturing on February 15, 2020. At yesterday’s close, its yield was 4.1%, well above the 3.74% mentioned above. Even so, the new yield still looks non-frightening.

Now for our second adjustment: the dissection of the time period. Expectations are rarely for a steady inflation rate throughout the 10-year period. At this time, investors likely anticipate low inflation for a period of time until the economy gets humming. Then the inflation risk rises.

The method for seeing these differing forecasts is to calculate the yield from one period to another. An example can show how this calculation works. Let’s look at two maturities: February 15, 2011 and February 15, 2012 (basically, one and two years). The yields are 0.43% and 0.98% for each. At 0.43%, $100.00 would rise to $100.43 in one year. At 0.98%, $100.00 would rise to $101.97 in two years.

Now, we have the numbers required to calculate the interest rate for the second year built into the two-year security. It is the rate that moves our investment from $100.43 to $101.97 in a year’s time. The rate is 1.53%, well above the 0.98% two-year average.

Look ahead one more year, and difference grows further. The February 15, 2013 bond has a yield of 1.62% (meaning $100.00 would grow to $104.94 over the three years). The third year’s move from $101.97 to $104.94 is an increase of 2.91% – almost double the rate for the entire period.

(As a side note, there is a bond investing strategy called “rolling down the yield curve” that seeks to capture the later high returns and avoid the earlier low ones. For example, buy the three-year security, then sell it one year later – when it has a two-year maturity – and buy the current three-year issue. IF yields stay in alignment, this move captures the 2.91% and sets up to earn the next one. That’s a big “if” in this market, as we will see next.)

Now, back to the interpretation of inflation. Yields typically rise as maturity lengthens because the further out an investor commits, the more uncertainty there is. If there is an additional concern about inflation, those rate increases should grow, leading to a “steep” yield curve. That is the situation today.

This graph shows the yield curve (using stripped securities), both on an average basis (what we see quoted) and on a one-year interval basis. Note the interval rates run up to the 6% area, a relatively high yield for US Treasury securities. And look at how long the rate stays in that area. This likely means bond investors are building in expectations of an extended bout of higher inflation – perhaps 4%-5%, well above the Federal Reserve’s desired level.

01-15 Stripped bond yield curve

If their expectations are roughly correct, long-term bond yields will rise (prices with fall) appreciably over the next few years as the economy picks up steam and inflation returns. So, now is still a good time to avoid bonds.

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