Not long ago bond yields were lower than the inflation rate. There were a number of articles commenting on the phenomenon. A common piece of advice in many of these articles was to invest in commodities. The basic logic was that low interest rates would cause inflation and “real assets” would benefit. Let’s take a look at what has actually happened when long term bonds offer negative real returns.
Since the inflation rate is a “monthly” data point, we will look at monthly data. The 30-year bond was reinstituted in February 1977 so the data starts there. Here are the months since then when the 30-year yield was trading below the rolling 12-month inflation rate as of the last day of the month:
Oct 1978 to Dec 1980
Jun 2008 to Sep 2008
Aug 2011 to Dec 2011
For those of you who are curious, the average premium for the 30-year bond yield over the inflation rate is 3.31%. If bonds would trade with the same premium at the current 1.70% rate of inflation, the 30-year bond yield would trade at 5.01%. This is 81% higher with June’s closing yield of 2.76%.
What was the premium low in each cycle?
June 1980 -4.39%
Sep 2005 -0.12%
July 2008 -1.00%
Sep 2011 -0.97%
What was the premium high in the cycle?
May 1984 9.61%
Oct 2006 3.41%
July 2009 6.41%
May 2012 0.97% (so far)
Besides the current situation, all the premium increase moves lasted at least a year and each premium cycle peak went above the long-term average of 3.31%.
So what happens next? Investors need to protect themselves against the ravages of inflation. So, theoretically at least, either bond yields should go up or inflation should go down. Which is it? Let’s take a look at bond yields and inflation from the premium cycle low to the premium cycle high. The most recent month in this article was May 2012 since we don’t have CPI data for June yet. It is extremely unlikely that the May 2012 premium of 0.97% will end up being the all-time peak in the cycle but we can get a sneak peak on how events are unfolding thus far.
June 1980 to May 1984 Yields went up 28.7%. The inflation rate went down 70.6%.
Sep 2005 to Oct 2006 Yields went up 8.5%. The inflation rate went down 55%.
July 2008 to July 2009 Yields went down 6.3%. The inflation rate went down 137%.
Sep 2011 to May 2012 Yields went down 7.9%. The inflation rate went down 56%.
Bonds had mixed results. On (compounded) average bond yields went up by 4.7% from the premium low to the premium high (which varied greatly with respect to time). So this indicator, in isolation, is moderately bearish for bondholders. But in every instance the inflation rate decreased by at least 55%.
What about stocks and commodities?
Dates Stocks Commodities
June 1980 to May 1984 31% -3.9%
Sep 2005 to Oct 2006 12% 15.4%
July 2008 to July 2009 -22% -24.9%
Sep 2011 to May 2012 15.8% -9.2%
Stocks went up a compounded average of 7.2%. Commodities went down a compounded average of 6.7%.
Of the three major asset classes, only stocks fared pretty well. Stocks had one outlier (in 2008), but it was a doozy. However, commodities did even worse during that time period. There was only one instance when commodities did better than stocks and that was only by 3.4%. This fits well with previous articles
which suggest one should be bullish on stocks but neutral on commodities.
So when you see negative bond yields you definitely want to take your chances with stocks over commodities. But the best predictive value of all with respect to negative bond yields is not financial but economic. Every time there have been negative bond yields, the inflation rate has declined by at least 55%. Negative real bond yields did not cause inflation, but rather predicted disinflation.
No positions in stocks mentioned.
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