A Blast From the Past – The Yield on 10-Yr Treasuries is Approaching the Inflation Rate

This is a very interesting discussion of what happened in the 1970s when the inflation rate exceeded 10-yr Treasuries. I remember that time. You borrowed as much as possible. Well, we are within 1/3 % of that today.

Hmmm, I wonder if a period of negative real interest rates along with a need for instant gratification is where the American public obtained its propensity to borrow? Text in bold is my emphasis. From Bloomberg:

For only the fourth time since Gerald Ford's presidency, oil is threatening to push the rate of inflation above 10-year Treasury yields. For bond investors basking in the biggest bull market since 2002, that's bad news.

Yields on 10-year notes fell as low as 3.79 percent last week, within a third of a percentage point of the consumer price index. Every time inflation has exceeded what investors get paid to own Treasuries, bonds have plunged. That happened from August 1973 through August 1975, when Ford addressed the nation with his ``Whip Inflation Now'' speech, and from January 1979 to October 1980, the end of Jimmy Carter's term.

``It's like the 70s,'' said Jim Rogers, a former partner of hedge fund manager George Soros who predicted the start of a commodities rally in 1999. Rogers said in an interview in Singapore that the rise in oil reminds him of when climbing fuel costs almost three decades ago caused 10-year yields to soar.

``We're in a period of a commodity bull market and inflation,'' Rogers said. ``I would not buy government long-term bonds. We'll be going down for years to come. Commodities are telling you to sell Treasuries. Inflation is everywhere.'' He holds positions that will benefit if Treasuries fall.

During the 1970s the 10-year note's yield, which moves inversely to its prices, rose to 12.4 percent by 1981 from 5.89 percent at the end of 1971. Normally, yields average 3.8 percentage points more than inflation, based on trading since 1987. Even if the relationship just reverts back to the 2.2- percentage-point average in the first half of the year, investors in 10-year notes would lose 0.8 percent.

``The inflation story going forward is going to be very different than what we've seen in the past,'' said E. Craig Coats Jr., co-head of fixed income at Keefe, Bruyette & Woods Inc. in New York, who began trading bonds in 1969 at Salomon Brothers. ``The inflation news is going to be worse.''

The yield on the benchmark 4 1/4 percent note maturing in November 2017 was little changed today at 3.94 percent, according to New York-based bond broker Cantor Fitzgerald LP.

Investors have sought Treasuries as a haven from widespread losses in mortgage markets even as consumer prices climbed 3.5 percent through October, the most since August 2006. U.S. government debt has returned 9 percent this year, including reinvested interest and price gains, the most since gaining 11.5 percent in 2002, according to Merrill Lynch & Co. data.

The combination has left the Federal Reserve with the dilemma of either cutting interest rates next week for a third time since September to prevent the housing slump from pushing the economy into recession or keeping rates steady to fight inflation. (It is worth the price of admission to stand around and watch this for the next 12 -24 months.)

``You've got to be thinking inflation is falling by a dramatic amount'' to buy bonds at their current yields, said Thomas Atteberry, who manages $2.3 billion in fixed income assets at First Pacific Advisors LLC in Los Angeles. ``I'm a little hard pressed to see that with the price for oil and the prices we're seeing for food. It's unsustainable.''

The central bank highlighted inflation concerns when it lowered its target for overnight loans between banks by a quarter point to 4.5 percent on Oct. 31. ``Readings on core inflation have improved modestly this year, but recent increases in energy and commodity prices, among other factors, may put renewed upward pressure on inflation,'' the Fed said in its statement.

In emphasizing so-called headline inflation risks, the Fed is including the impact of rising food and energy prices, which are more volatile than other items tracked in the index and usually excluded from the central bank's projections.

Fed Chairman Ben S. Bernanke signaled ``renewed turbulence'' in credit markets may have shifted risks between growth and inflation during a speech in Charlotte, North Carolina, on Nov. 29, adding to speculation the central bank will cut rates again. Financial futures traded on the Chicago Board of Trade show that there is a 68 percent chance the Fed lower rates at least a quarter of a percentage point on Dec. 11.

The average price of a barrel of oil was $6.87 in 1974, 77 percent higher than in 1973, according to the U.S. Energy Information Administration. The average price of crude tripled from January 1979 to January 1981 to $28.81, agency data shows.

Keefe, Bruyette's Coats said his forecast for faster inflation is based on demand from China, India and other emerging-market economies for oil and other commodities, demand that wasn't there in the 1970s. Global growth presents investors with ``a very different scenario'' than earlier periods, he said.

In October 1974, one month after appointing Alan Greenspan as his chief economic adviser, Ford urged the U.S. to conserve energy and increase productivity to overcome acceleration in the consumer price index, which reached 12.1 percent that month. The 10-year Treasury yield ended the month at 7.8 percent.

``I say to you with all sincerity that our inflation, our public enemy number one, will, unless whipped, destroy our country, our homes, our liberties, our property, and finally our national pride, as surely as any well-armed wartime enemy,'' Ford said.

Ford also drew attention to a button on his lapel with the letters WIN for whip inflation now. ``It bears the single word WIN,'' he said. ``I think that tells it all.''

The Misery Index, created by the economist Arthur Okun, an adviser to President Lyndon Johnson, is the sum of the unemployment and inflation rates. The index peaked in June 1980 during the Carter administration, when the jobless rate reached 7.6 percent and consumer prices rose 14.4 percent.

Both instances of negative real yields in the 1970s were caused by the central bank's unwillingness to tackle rising prices by raising rates, said Lyle Gramley, a Carter economic adviser from 1977 until he was appointed a Fed governor in 1980.

Carter's appointment of Paul Volcker to head the Fed in 1979 was an acknowledgment of the severity of the economy's problems, Gramley said in an interview. ``There wasn't any alternative other than very tough monetary policy.''

Volcker ended up boosting the central bank's target rate to 20 percent in 1980. Should real yields swing into negative territory it will be a ``unique'' consequence of the flight to quality, Gramley said.