By Paul H. Kupiec

On August 18, the 10-year Treasury note yield was 1.263
percent, far less than 12-month CPI inflation rate of 5.39 percent through June.
According to a common measure, the ex ante real yield — the yield adjusted for the
impact of inflation — was 3.87 percent, the lowest ex ante real yield
recorded since the early 1980s, a period characterized by soaring inflation and
Treasury yields. Some argue that the past is prologue and today’s Treasury note
investors should prepare for huge losses. While Treasury investors today may
well face future losses, an accurate reading of the historical record does not presage
such a prediction. In the past, periods with negative ex ante real yields were,
far more often than not, periods in which Treasury notes held-to-maturity
yielded positive real returns. 

A popular financial blog compares current conditions in the Treasury market to the period “between 1973 and late-1980, [when] bond investors got totally crushed, by rising yields and therefore dropping prices, and by very high inflation which for most of that time was higher, and for years, a lot higher, than the bond yield.” The clear implication being that, with real yields testing historical lows, Treasury note investors would be naïve if they did not consider the potential of losses in the face of surging inflation.

The prediction of impending losses focuses on a common
measure of the Treasury note’s ex ante real yield calculated as the 10-year
Treasury note yield minus the lagging 12-month CPI inflation rate. Folklore
holds that note yields historically are slow to rise in response to surging
inflation because of investor over-confidence in the Fed’s ability to reign in surging
inflation. When investors realize their mistake, note yields rise sharply.
Because rising yields cause the prices of outstanding notes to fall, the jump
in yields causes widespread losses for those holding Treasury securities.

Chart 1 plots historical Treasury yields and annual CPI inflation rates over the last 60 years. The data are sourced from the Federal Reserve Bank of St Louis FRED database. Negative ex ante real rates, a phenomenon that allegedly foreshadows subsequent Treasury note losses, occurred between September 1973, and August 1975, and again between October 1978 and October 1980. A careful look at the data from this period shows that investors who held their notes to maturity, rather than being “crushed,” for the most part not only earned positive real returns, but in some instances some of the highest real Treasury note yields available over the last sixty years.

I calculate the actual ex-post real yields on Treasury notes
for the period 1960 to 2011, the final year for which ten-year ahead inflation
data is available. I assume that a new Treasury note is issued each month at
par and project the note’s semi-annual cash flows for the following ten years.
I use the actual change in the CPI over each note’s lifetime to calculate the
inflation-adjusted (real) cash flows associated with each note at the date of
note issuance. I calculate the ex-post real yield as the yield that equates the
discounted value of each note’s inflation-adjusted cash flows to the par value
of the note.

Chart 2 plots historical ex ante real and ex-post real
Treasury note yields. Chart 2 clearly shows that the vast majority of months
with negative ex ante real yields actually returned positive real yields for
investors who held their notes to maturity. The early 1980s was a period of
exceptionally large negative ex ante real Treasury note yields and yet
investors who held these notes to maturity earned some of the highest real returns
available over this 50-year period. The ex-post real rate data suggest that the
investors that got “crushed” were investors that purchased notes between late-1963
and early-1973, a period over which nominal note yields were higher than the
lagging 12-month CPI inflation rate but realized ex post real yields were
mostly below zero.

The ex ante real yield measure of Treasury market conditions is mentioned in many reports covering Treasury markets. How can such a widely used measure be so flawed? The ex ante real-yield can be misleading for two reasons: (1) the lagging 12-month CPI inflation rate is not an accurate forecast of inflation over the notes’ 10-year life; and (2) when Treasury notes are held to maturity, mark-to-market losses on outstanding notes caused by yield increases are attenuated as the note approaches maturity and returns its par value.

This brief analysis of the historical record, while informative, does not in my opinion provide any guidance on how current Treasury notes may perform going forward. Current nominal Treasury note yields are exceptionally low in part because of massive Federal Reserve QE purchases that were absent in historical episodes. Moreover, inflationary pressures are strong and likely to persist if Congress passes the pending infrastructure and budget reconciliation bills. Under current conditions, the common disclaimer on securities prospectuses, “Past performance is no guarantee of future results” has never been more apropos.

The post Treasury yields, inflation, and real interest rates: Analyzing the historical record appeared first on American Enterprise Institute – AEI.