How high can yields go? A thought experiment

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The question on the minds of many traders these days is “How high can yields go in this bond bear market?” Smart economists and portfolio managers have been calling the bottom in bonds all the way down, while others believe there is still more downside. In this post I attempt to approach this question using multiple mental models.

Real yields

The 10 yr real yield (the spread of nominal yields over the 10 yr breakeven yield, as measured by TIPS bonds) sits at 2.36% today, the highest it has been since 2008. The 10 yr breakeven inflation yield (currently 2.38%) is the market-based expectation of inflation over the next 10 years, so that means that buying Treasuries today and holding 10 years to maturity will get you a yield of 2.36% above inflation.

US 10 yr nominal yields - 10 yr TIPs yields. This data series only goes back to 1999. US real yields provide the best value in 15 years. What’s the catch?

After everything we’ve been through over the last three years, who believes that inflation will average 2.38% over the next ten years, which is what inflation breakevens are pricing in? I certainly don’t. Considering structural factors that point towards higher inflation down the road, I will take the over on that bet.

Let’s also not forget higher US deficits juicing the economy and the Fed’s likely return to QE and monetization of debt

What if we use core-CPI instead of the TIPS yield as our inflation measure? It’s not perfect as it’s more volatile and laggy, and core-CPI sits at 4.1% today, which is double the Fed’s inflation target. But let’s see what 10 yr real yields look like using core-CPI:

US 10 yr nominal yields - core CPI

The real yield is a modest 42 bp if we assume inflation will average 4.1% over the next 10 years. You can see that in the 1970’s and 1980’s when inflation was out of control, this measure of real yields went much higher. If we are permanently entering a higher inflation regime, then 10 yr Treasuries can certainly get much cheaper.

Based on this, 10-year Treasuries might offer value to some pensions funds whose liabilities are expected to increase at the rate of core inflation, or slightly higher. However, for the average household, this level of real yields doesn’t offer much additional return other than strictly store of wealth and preservation of buying power. Treasuries have failed as a hedge against equity market drawdowns, which removes one key pillar for why they belong in portfolios. Which brings me to the next model…