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Adjusted for Inflation, 30-Year Yields Are Collapsing

by: Gary Smith posted on: February 19, 2008 | about stocks: GKE / IPE / TIP / TLO / TLT

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The bond market is clearly sending signals that U.S. inflation is accelerating, according to Mark Gilbert in Bloomberg, and this should concern investors. As Gilbert notes:

The two-year Treasury note yield has more than halved since Sept. 18, the day the Federal Reserve started cutting its key interest rate. The current yield of about 1.92 percent is far enough below the Fed's 3 percent rate to suggest investors expect additional moves from the U.S. central bank.

It's a different story at the other end of the yield curve. At about 4.6 percent, the 30-year bond yield is only 15 basis points lower than it was when the Fed downshifted into easing mode. As a result, the yield curve has steepened, driving the gap between the two- and 30-year securities to its widest level since July 2004 at about 268 basis points.

... The gap between five- and 20-year breakevens has widened to 65 basis points, the most since at least August 2004 and more than double the 2007 average.

But Fed policy may be laying the path for future higher inflation, Gilbert warns. He reports that the futures market is factoring in a 70-percent chance that the Fed will cut a further 0.5 percent off its key rate at its next meeting in mid-March, with a 30-percent likelihood that the Fed will trim its rate by 75 basis points. And the result: Adjusting for annual inflation, 30-year yields are collapsing. As Gilbert explains:

In November, inflation jumped to 4.4 percent, matching the yield on the 30- year security to produce a real yield of zero for the first time in more than two years. The real yield is now about 0.5 percent... Avery Shenfeld, the senior economist at CIBC World Markets Inc. in Toronto, is predicting a 4.4 percent inflation rate. [January inflation figures are published tomorrow]. At current values, that would slap the real yield on 30-year bonds back down to 0.2 percent.

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