Are Bond Yields Accurately Forecasting Future Inflation?

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Are Bond Yields Accurately Forecasting Future Inflation?

Post by SimpleGift » Thu Feb 20, 2020 6:24 pm

In theory, the buyer of a 10-year nominal bond should have an informed idea of the average inflation rate over the next 10 years. To test this theory, the chart below plots the annual yield of the 10-year Treasury bond since 1950 against the average inflation rate for each subsequent 10-year period.

Results. Prior to 1975, yields were a reasonably good match for subsequent inflation. However, for the next 30 years after the oil and inflation shocks of the late 1970s, bond buyers demanded nominal yields that were far higher than the subsequent realized inflation. Only in the last decade have bond yields and subsequent inflation become more accurately aligned.
Discussion. Clearly, the bond market can and has had periods when inflation expectations were anchored primarily on past history, rather than an accurate forecast of future inflation. To my mind, this indicates that investors with a significant portfolio allocation to bonds should not fall asleep to the risk of future high inflation — even when yields and market expectations are currently so low.

Your thoughts?

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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by Thesaints » Thu Feb 20, 2020 6:29 pm

No. Of course, I may add.
For the same reason, the spread TIPS/Fixed rate is also not a predictor of future inflation, but only an accurate measure of the market's forecasted inflation.

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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by Tdubs » Thu Feb 20, 2020 6:36 pm

On a happier note, we could say that 10-year bonds almost always beat inflation

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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by SimpleGift » Thu Feb 20, 2020 9:11 pm

What prompted the OP was reading Forum posts in which members are shedding their TIPS, or REITs, or commodity stock allocations in the interest of "portfolio simplification" or because "inflation is dead."

Yes, the bond market is telling us the current 30-year breakeven inflation rate is only 1.8%, but history tells us that inflation regimes can change in a hurry. In the short term, a serious unexpected inflation shock is not hard to envision (e.g., a simple blockage of the Strait of Hormuz). In the longer term, government debt overhangs are expanding rapidly worldwide — and while these debt loads are sustainable at today's low sovereign rates, even modestly higher rates could easily tip toward fiscal crisis, and/or debt monetization with higher inflation.

In short, it seems short-sighted today to abandon portfolio inflation protection — especially for portfolios heavy in bonds — even if market inflation forecasts are currently quite low. Just my two cents.

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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by aristotelian » Thu Feb 20, 2020 9:14 pm

Nobody can tell the future. Certainly they reflect expectations of future inflation. Whether the expectations are accurate will only be known in hindsight.

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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by Thesaints » Thu Feb 20, 2020 9:30 pm

SimpleGift wrote:
Thu Feb 20, 2020 9:11 pm
What prompted the OP was reading Forum posts in which members are shedding their TIPS, or REITs, or commodity stock allocations in the interest of "portfolio simplification" or because "inflation is dead."

Yes, the bond market is telling us the current 30-year breakeven inflation rate is only 1.8%, but history tells us that inflation regimes can change in a hurry. In the short term, a serious unexpected inflation shock is not hard to envision (e.g., a simple blockage of the Strait of Hormuz). In the longer term, government debt overhangs are expanding rapidly worldwide — and while these debt loads are sustainable at today's low sovereign rates, even modestly higher rates could easily tip toward fiscal crisis, and/or debt monetization with higher inflation.

In short, it seems short-sighted today to abandon portfolio inflation protection — especially for portfolios heavy in bonds — even if market inflation forecasts are currently quite low. Just my two cents.
Inflation is caused by a relative abundance of money available to be spent on goods/services included in whatever inflation measure is used, with respect to the abundance of those goods/services available to be exchanged.
At present, there is no doubt there is an abundance of money, although it is not in the hands of those who would spend it on goods/services included in the CPI-U basket. It is not a given that it eventually will find its way into those hands either. There could still be a relative shortage of goods/services, but productivity and occupation are both high. Maybe something like reduced flow of goods from abroad...

Clearly we are instead seeing "inflation" in the price of financial securities. That too is undeniable.

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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by SimpleGift » Thu Feb 20, 2020 10:04 pm

^^^ Looking ahead, it's also becoming increasingly possible that the future of inflation may be largely politically determined, rather than economically determined. As a recent report from Deutsche Bank notes:
Deutsche Bank wrote:Future inflation outcomes could also be a battle between the temptation to inflate away the excessive debts we’re left with post the 40-50 year credit binge and the fact that we currently have independent central banks with specific low inflation mandates.
Though discussions of future monetary and inflation policy are not allowed on the Forum, as a bond investor it would be myopic to ignore the forecasts of immense future government budget deficits.

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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by boglerdude » Fri Feb 21, 2020 12:36 am

Is it a free market if fed or primary dealers are required to buy treasuries

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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by willthrill81 » Fri Feb 21, 2020 12:48 am

aristotelian wrote:
Thu Feb 20, 2020 9:14 pm
Nobody can tell the future. Certainly they reflect expectations of future inflation. Whether the expectations are accurate will only be known in hindsight.
I've wondered for a bit now whether expectations of low inflation among consumers tend to become a self-fulfilling prophecy. It seems to be true of expectations of high inflation, as David Stein discussed on the latest episode of his Money for the Rest of Us podcast.
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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by Angst » Fri Feb 21, 2020 1:07 am

SimpleGift wrote:
Thu Feb 20, 2020 6:24 pm
In theory, the buyer of a 10-year nominal bond should have an informed idea of the average inflation rate over the next 10 years. To test this theory [Snip...]

[Snip...]
I'm not sure I understand how this tests your theory. Ought we expect the 10 yr bond rate curve to parallel subsequent 10 yr inflation? Why? Are there not other reasons (besides lack of correct information) that can justify, up front, an eventual variance in the spread between the 10 yr rate and realized 10 yr inflation? I somehow think so, but don't have good examples off the top of my head. I will say that I do wish we had 10 yr TIPS data going back that far so we could see a third variable in the graph! Thank you for your post.

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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by watchnerd » Fri Feb 21, 2020 2:09 am

SimpleGift wrote:
Thu Feb 20, 2020 9:11 pm
What prompted the OP was reading Forum posts in which members are shedding their TIPS, or REITs, or commodity stock allocations in the interest of "portfolio simplification" or because "inflation is dead."
What, I'm supposed to sell my short TIPS now?

Darnit, I was just getting warmed up to them and their boring ways.
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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by NotTooDeepLearning » Fri Feb 21, 2020 3:32 am

SimpleGift wrote:
Thu Feb 20, 2020 9:11 pm
What prompted the OP was reading Forum posts in which members are shedding their TIPS, or REITs, or commodity stock allocations in the interest of "portfolio simplification" or because "inflation is dead."

Yes, the bond market is telling us the current 30-year breakeven inflation rate is only 1.8%, but history tells us that inflation regimes can change in a hurry. In the short term, a serious unexpected inflation shock is not hard to envision (e.g., a simple blockage of the Strait of Hormuz). In the longer term, government debt overhangs are expanding rapidly worldwide — and while these debt loads are sustainable at today's low sovereign rates, even modestly higher rates could easily tip toward fiscal crisis, and/or debt monetization with higher inflation.

In short, it seems short-sighted today to abandon portfolio inflation protection — especially for portfolios heavy in bonds — even if market inflation forecasts are currently quite low. Just my two cents.
Great point. Ray Dalio/Bridgewater recently wrote an article about not over-extrapolating the recent past, as it seems everyone is doing now with inflation.

https://www.linkedin.com/pulse/paradigm ... ray-dalio/

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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by Valuethinker » Fri Feb 21, 2020 3:57 am

SimpleGift wrote:
Thu Feb 20, 2020 6:24 pm
In theory, the buyer of a 10-year nominal bond should have an informed idea of the average inflation rate over the next 10 years. To test this theory, the chart below plots the annual yield of the 10-year Treasury bond since 1950 against the average inflation rate for each subsequent 10-year period.

Results. Prior to 1975, yields were a reasonably good match for subsequent inflation. However, for the next 30 years after the oil and inflation shocks of the late 1970s, bond buyers demanded nominal yields that were far higher than the subsequent realized inflation. Only in the last decade have bond yields and subsequent inflation become more accurately aligned.
Discussion. Clearly, the bond market can and has had periods when inflation expectations were anchored primarily on past history, rather than an accurate forecast of future inflation. To my mind, this indicates that investors with a significant portfolio allocation to bonds should not fall asleep to the risk of future high inflation — even when yields and market expectations are currently so low.

Your thoughts?
Put it another way, the bond market does not understand macroeconomic regime change -- or it takes a very long time in convincing.

The Central Banks, led by the Fed and the Bank of England in the early 1980s, moved towards de facto, and then de jure (the European Central Bank has inflation control in its charter, I believe), targetting of inflation rates.

Thus the course of inflation was set to fall to within, and then below, Central Bank targets.

This has bigger impacts. The recessions of 2000-01 (relatively mild) and the Global Financial Crisis and "the Great Recession" of 2008-09 did not follow the historical pattern.

The historical pattern of rising inflation followed by the Fed stamping on the break - of recession induced by monetary policy - did not follow the historical pattern.

Instead, you had asset price bubbles that the Central Banks did not move against, because there was no corresponding response in CPI inflation. And eventually those asset bubbles popped - the Tech Media Telecoms one in 2000, the US housing market one (and associated international bubbles like Iceland) in 2007-08, with the fall of Lehman Brothers turning a downturn into a panic and a crisis.

The outlook? Who knows. As long as Central Banks are independent and able to target inflation, it's unlikely that inflation and inflationary expectations will loose their anchor.

It is abundantly clear the market expectation of an economic variable is not a good guide to outcomes in the long run.

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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by Valuethinker » Fri Feb 21, 2020 4:04 am

SimpleGift wrote:
Thu Feb 20, 2020 9:11 pm
What prompted the OP was reading Forum posts in which members are shedding their TIPS, or REITs, or commodity stock allocations in the interest of "portfolio simplification" or because "inflation is dead."

Yes, the bond market is telling us the current 30-year breakeven inflation rate is only 1.8%, but history tells us that inflation regimes can change in a hurry. In the short term, a serious unexpected inflation shock is not hard to envision (e.g., a simple blockage of the Strait of Hormuz).
If the Central Banks do not ease off, that can simply cause a reallocation of money. More money goes into oil and oil related economic activity. There would also be supply-side disruptions (which would be very large) as the economies of a lot of countries shut down. Many of us remember some form of petrol rationing (such as odd-even day rules for gasoline purchases) taking place in the 1970s.

The economy is structurally different, now. There were big transport and industrial trade unions that could strike and demand CPI-linked contracts, thus reinforcing an inflationary spiral. After Reagan broke PATCO (air traffic controllers union) that relationship in the US economy just disappeared. Other developed countries have followed a similar course - the UK managed 10 years of below inflation pay rises without sustained national disruption.
In the longer term, government debt overhangs are expanding rapidly worldwide — and while these debt loads are sustainable at today's low sovereign rates, even modestly higher rates could easily tip toward fiscal crisis, and/or debt monetization with higher inflation.

In short, it seems short-sighted today to abandon portfolio inflation protection — especially for portfolios heavy in bonds — even if market inflation forecasts are currently quite low. Just my two cents.
Tax rates are also a lot lower than they were in the 1970s. Many countries could raise taxes to service higher debt interest levels. And there's a lot more inflation protected government debt around (c. 30% of total UK government bonds in issue, by total value). So governments are less tempted to inflate away - because it doesn't work as well in their favour, fiscally.

I agree that we should not ignore the benefits of inflation protection. It's a defect of human judgement that we think in nominal, not real, terms. We should care about constant real value of our savings, not nominal. But "safety" is seen as constant nominal value. For low inflation rates that only matters in the long run.

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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by rossington » Fri Feb 21, 2020 4:36 am

SimpleGift wrote:
Thu Feb 20, 2020 9:11 pm
In the short term, a serious unexpected inflation shock is not hard to envision (e.g., a simple blockage of the Strait of Hormuz).
What country is capable of this with the inevitiable U.S. response? Not going to happen.
In the longer term, government debt overhangs are expanding rapidly worldwide — and while these debt loads are sustainable at today's low sovereign rates, even modestly higher rates could easily tip toward fiscal crisis, and/or debt monetization with higher inflation.
What in the foreseeable future will cause rates to rise? There is no evident rationale for this to happen.
In short, it seems short-sighted today to abandon portfolio inflation protection — especially for portfolios heavy in bonds — even if market inflation forecasts are currently quite low. Just my two cents.
Agreed here, although I think a TBM return is worth the additional risk over TIPS in this environment.
"Success is going from failure to failure without loss of enthusiasm." Winston Churchill.

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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by Valuethinker » Fri Feb 21, 2020 4:46 am

rossington wrote:
Fri Feb 21, 2020 4:36 am
SimpleGift wrote:
Thu Feb 20, 2020 9:11 pm
In the short term, a serious unexpected inflation shock is not hard to envision (e.g., a simple blockage of the Strait of Hormuz).
What country is capable of this with the inevitiable U.S. response? Not going to happen.
You don't have to close the Straits, so much as disrupt. For example if tankers cannot get insurance. In a world of commercially available drones, this is quite possible.

Any threat like that could send the price of oil shooting up.

We are in an age of disruption. New technologies like UAVs/ drones (and there are submersible drones) can disrupt the strategic balance in new ways. Hezbollah is in many ways a prototype for modern "4th Generational" (or 5th?) warfare.

Whether that would lead to a repeat of the 1970s I doubt, because the western world no longer has trade unions in critical parts of the economy, able to bring them to a halt*. We have left the world of CPI indexed labour cost contracts.

The 1970s also had a food price boom. The USSR's harvest failed, and to avert unrest, it sent its buyers scrambling into world markets, just as the oil price shock hit. The real price of grain probably reached a level it had not seen since 1910 (when it was at an all time historic peak).

Food was a much bigger part of the household budget in the 1970s - around 30% from memory in UK, Canada and USA (largely, we have halved the cost of store bought food, and supplemented our spending with far more eating out "casual dining" and fast food). So that price shock (and grain is of course bread, cereal, baked goods, meat, milk) really hit the consumer.

But again you could see severe disruptions of food supply, likely due to weather related conditions, cause a shortage of key foodstuffs & soaring prices. Or even just a nasty plant blight - we are critically dependent on a rather small genome in terms of core foodstuffs (which are wheat related, chiefly, globally). If something goes wrong in the weather in the US Midwest, Ukraine, Argentina and Australia, then the world grain supply is sharply curtailed.
In the longer term, government debt overhangs are expanding rapidly worldwide — and while these debt loads are sustainable at today's low sovereign rates, even modestly higher rates could easily tip toward fiscal crisis, and/or debt monetization with higher inflation.
What in the foreseeable future will cause rates to rise? There is no evident rationale for this to happen.
We are assuming the major Central Banks continue with their anti inflation stance (and anti inflation DNA). That there could never be political tampering with the Central Banks.
In short, it seems short-sighted today to abandon portfolio inflation protection — especially for portfolios heavy in bonds — even if market inflation forecasts are currently quite low. Just my two cents.
Agreed here, although I think a TBM return is worth the additional risk over TIPS in this environment.
[/quote]

US inflation protection at least pays a positive real yield. The UK equivalent is trading at minus 1.9% real. Unless inflation exceeds expectations by 1.9% pa you are guaranteed to lose money in real terms.

* the UK truck drivers' blockade of petrol refineries in 2000 is a counterexample. And indeed the CIA in Chile made sure that the truckers struck. So there are still some choke points. But the dock workers, say, are no longer capable of stopping international commerce.

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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by Chicken Little » Fri Feb 21, 2020 5:53 am

SimpleGift wrote:
Thu Feb 20, 2020 10:04 pm
Though discussions of future monetary and inflation policy are not allowed on the Forum, as a bond investor it would be myopic to ignore the forecasts of immense future government budget deficits.
It's essential to consider this. On the fixed income side, it's similar to looking at stock market valuations. Does the degree of "safety" on the fixed income side vary over time? Do you have the same level of safety now compared to what you would've had in 1980?

It's kind of crazy times right now; low worldwide rates, high debt of all stripes, and active political debate about public bailout next (free college, free healthcare, UBI etc). Risk-parity, "inflation-is-dead", "Why do you hold bonds?". It's crazy right now.

The latter is actually a great question. I'm worried about bonds not because of opportunity-loss in stocks, but because of default risk. How much of that corporate will go up in smoke in a significant downturn? The government can't default, but they can certainly monetize. There really isn't any choice (I don't have an opinion on what policy should or shouldn't be - besides being a prohibited activity, discussion is a waste of time...there is no choice. The emperor has no clothes. What's China doing right now? Stimulus, right?).

What happens if everyone tries to unload debt at the same time?

The post about declining rates was interesting, but I kind of lost the conversation. Was anybody suggesting that I should follow that line? Where is that supposed to leave us in 25-50 years? Will we all be taking out mortgages and getting paid by banks?

I think we'll see inflation again in my time horizon. I am considering increasing TIPs, lightening/eliminating corporate/agency, increasing treasuries, shortening term, and increasing equities. I just can't get away from the fact that any economic shock will precipitate an acute decline in stocks - typical - before erosion of fixed income commences. The Fed has to lower in the face of crisis, but how long can that go on? To -5, -10, -15%? Eventually there will be an inflection point.

So for now I am in kind of a holding pattern. If there's a sharp downturn, I'll probably make those shifts. It's not good times. I don't like owning any of this.

"Inflation-is-dead". Then it would be "different-this-time", right?

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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by Chicken Little » Fri Feb 21, 2020 6:02 am

Here's a follow-up...what won't be contagion? How can't the next recession be "big".

I remember the fallout from 2008 with all the CDSs. There were definitely circles, with people making money writing financial insurance. Company A borrows from B, B buys insurance on default from C, C buys insurance on default from A.

If there were any kind of debt crisis, how would it not be "contagion" by definition. What happens to the insurance industry? Pensions?

I hope it goes on like this forever. Steady, reasonable, orderly, incessant devaluation. That's better than any alternative.

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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by dkturner » Fri Feb 21, 2020 7:34 am

Tdubs wrote:
Thu Feb 20, 2020 6:36 pm
On a happier note, we could say that 10-year bonds almost always beat inflation
No, we can’t.

The real (inflation adjusted) return on 10 year Treasuries has exhibited very long periods when its return was seriously negative. For the 41 year period of 1941-1981 the real return of 10 year Treasuries was a NEGATIVE 2.26%. This was a period of high inflation (4.7%). In recent years (1982-2019) your observation has been correct, since 10 year Treasuries have produced real returns of a positive 4.95%.

The moral of the story is that the real return on bonds can remain negative for many successive decades. It’s probably not a good idea to bet on future high real returns because, for the last 7 years, the real return on 10 year Treasuries has dropped to only .47%, and the current yield (1.5%) is running below the rate of inflation.

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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by YearTrader » Fri Feb 21, 2020 8:02 am

It's totally normal that the market cannot accurately predict things, that's why we have risk premium.

I'd be more concerned if the market exception is asymmetrically way off, e.g. being too optimistic and simply extrapolating the past ten years. But how do I know.

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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by SimpleGift » Fri Feb 21, 2020 11:43 am

NotTooDeepLearning wrote:
Fri Feb 21, 2020 3:32 am
Great point. Ray Dalio/Bridgewater recently wrote an article about not over-extrapolating the recent past, as it seems everyone is doing now with inflation.

https://www.linkedin.com/pulse/paradigm ... ray-dalio/
Thanks for the link. Always enjoy reading Ray Dalio's commentary and his focus on the macro — even if it's overly longwinded most of the time. Here's his succinct summary, reflecting the point of this thread:
Ray Dalio wrote:Identify the paradigm you’re in, examine if and how it is unsustainable, and visualize how the paradigm shift will transpire when that which is unsustainable stops.
He goes on to point out that there are always large, unsustainable forces that drive the current paradigm — and that they go on long enough for people to believe that they will never end, even though they obviously must end. Food for thought about today's low inflation regime.

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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by petulant » Fri Feb 21, 2020 1:13 pm

SimpleGift wrote:
Fri Feb 21, 2020 11:43 am
NotTooDeepLearning wrote:
Fri Feb 21, 2020 3:32 am
Great point. Ray Dalio/Bridgewater recently wrote an article about not over-extrapolating the recent past, as it seems everyone is doing now with inflation.

https://www.linkedin.com/pulse/paradigm ... ray-dalio/
Thanks for the link. Always enjoy reading Ray Dalio's commentary and his focus on the macro — even if it's overly longwinded most of the time. Here's his succinct summary, reflecting the point of this thread:
Ray Dalio wrote:Identify the paradigm you’re in, examine if and how it is unsustainable, and visualize how the paradigm shift will transpire when that which is unsustainable stops.
He goes on to point out that there are always large, unsustainable forces that drive the current paradigm — and that they go on long enough for people to believe that they will never end, even though they obviously must end. Food for thought about today's low inflation regime.
Seems to me the paradigm is safe U.S. treasury debt with low inflation. Treasury debt has been a winner in every crisis for the last 30 years. Our mantra on BH is often bonds for safety, especially Treasury bonds (a la Swedroe). The repo market is based primarily on Treasury bonds; adding MBS, and then the unfolding of MBS problems, created the liquidity crisis in the 2008 crash. Central banks and commercial banks around the world have dollars or Treasury bonds as the core reserve. It seems like we have a low-probability high-magnitude problem if something happens to U.S. treasury debt: our bonds implode, our stocks probably implode, the repo market implodes, and the international financial system locks up. Do TIPS or real estate or anything help with this risk?

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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by Thesaints » Fri Feb 21, 2020 1:51 pm

petulant wrote:
Fri Feb 21, 2020 1:13 pm
Treasury debt has been a winner in every crisis for the last 30 years. Our mantra on BH is often bonds for safety, especially Treasury bonds (a la Swedroe).
Oh, yeah. Those who bought long term treasuries in 1968 were truly ecstatic in 1983.

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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by 12thKnight » Fri Feb 21, 2020 2:46 pm

Really glad to see a thread on future inflation rates here.

If the relationship between yields and future inflation is not directly and exclusively causal, then the use of yields as a leading indicator is subject to weakness. To that point, there are any number of reasons that inflation could be triggered. An energy scarcity crisis was already mentioned, but good old-fashioned Keynesian wage-push inflation could even be more likely, and could be prompted by something as simple as a revision to the federal minimum wage standard which has not been updated in over ten years.

In short, there are far too many variables which could produce an increase in inflation. It would seem especially risky for any investor, advisor, planner or software engine to carry an assumption that ten year inflation would fall below the Fed target of 2.0%. The inherent high volatility of inflationary rates should demand a more conservative approach when modeling the expectation of real return and derived income.

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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by willthrill81 » Fri Feb 21, 2020 3:08 pm

Valuethinker wrote:
Fri Feb 21, 2020 3:57 am
It is abundantly clear the market expectation of an economic variable is not a good guide to outcomes in the long run.
You mean that the wisdom of the crowd does not extend to forecasting? :wink:

If not, then that means that the crowd's 'wisdom' may not be all that useful.
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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by Doc » Fri Feb 21, 2020 5:06 pm

SimpleGift wrote:
Thu Feb 20, 2020 6:24 pm
In theory, the buyer of a 10-year nominal bond should have an informed idea of the average inflation rate over the next 10 years. To test this theory,

...

Your thoughts?
Once upon a time there were comments I think here, that one of (or maybe the) reason for the introduction of TIPS was to get a market view of future inflation. I believe that idea has been long abandoned.
A scientist looks for THE answer to a problem, an engineer looks for AN answer and lawyers ONLY have opinions. Investing is not a science.

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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by petulant » Fri Feb 21, 2020 5:28 pm

Thesaints wrote:
Fri Feb 21, 2020 1:51 pm
petulant wrote:
Fri Feb 21, 2020 1:13 pm
Treasury debt has been a winner in every crisis for the last 30 years. Our mantra on BH is often bonds for safety, especially Treasury bonds (a la Swedroe).
Oh, yeah. Those who bought long term treasuries in 1968 were truly ecstatic in 1983.
Was 1968 or 1983 in the last 30 years? It's important to have basic math before doing bonds, I would say. ;)

I suppose the comment highlights my point, though, which is that we have built a financial system on the stability of U.S. treasury debt, but it's not unthinkable that treasury debt becomes actually abysmal. It was not a good asset in the 1965-1980 period.

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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by ray.james » Fri Feb 21, 2020 5:35 pm

I am surprised how much smooth the inflation curve is compared to 10 yr yield. Std-deviation of both curves will be interesting data to look at.

To me, all the above graph demonstrates, investors always over-react and uncertainty is truly the cause of volatility. I guess that's why buy and hold works. Further on inflation, it seems human nature is to worry and as such we seem to over expect inflation. Except for true surprises that are rare(once ?)

Another great post, SimpleGift.
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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by SimpleGift » Sat Feb 22, 2020 10:38 am

ray.james wrote:
Fri Feb 21, 2020 5:35 pm
I am surprised how much smooth the inflation curve is compared to 10 yr yield.
Since the OP chart is comparing the annual yield of the 10-year Treasury bond against the 10-year average of the subsequent inflation rate, the inflation series appears much smoother.

The chart is just trying to show how the bond market's forecast of future inflation is often wildly inaccurate — and suggesting that investors not be lulled into thinking that today's low inflation regime will last forever and ever.

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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by willthrill81 » Sat Feb 22, 2020 10:51 am

SimpleGift wrote:
Sat Feb 22, 2020 10:38 am
ray.james wrote:
Fri Feb 21, 2020 5:35 pm
I am surprised how much smooth the inflation curve is compared to 10 yr yield.
Since the OP chart is comparing the annual yield of the 10-year Treasury bond against the 10-year average of the subsequent inflation rate, the inflation series appears much smoother.

The chart is just trying to show how the bond market's forecast of future inflation is often wildly inaccurate — and suggesting that investors not be lulled into thinking that today's low inflation regime will last forever and ever.
That's why I really shake my head at all of those who turn their nose up at TIPS right now. The break-even inflation rate on 10 year TIPS right now is just 1.61%. There isn't much downside to that unless you believe that deflation has a meaningful chance of occurring.
Last edited by willthrill81 on Sat Feb 22, 2020 10:51 am, edited 1 time in total.
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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by rustymutt » Sat Feb 22, 2020 10:51 am

Thesaints wrote:
Thu Feb 20, 2020 9:30 pm
SimpleGift wrote:
Thu Feb 20, 2020 9:11 pm
What prompted the OP was reading Forum posts in which members are shedding their TIPS, or REITs, or commodity stock allocations in the interest of "portfolio simplification" or because "inflation is dead."

Yes, the bond market is telling us the current 30-year breakeven inflation rate is only 1.8%, but history tells us that inflation regimes can change in a hurry. In the short term, a serious unexpected inflation shock is not hard to envision (e.g., a simple blockage of the Strait of Hormuz). In the longer term, government debt overhangs are expanding rapidly worldwide — and while these debt loads are sustainable at today's low sovereign rates, even modestly higher rates could easily tip toward fiscal crisis, and/or debt monetization with higher inflation.

In short, it seems short-sighted today to abandon portfolio inflation protection — especially for portfolios heavy in bonds — even if market inflation forecasts are currently quite low. Just my two cents.
Inflation is caused by a relative abundance of money available to be spent on goods/services included in whatever inflation measure is used, with respect to the abundance of those goods/services available to be exchanged.
At present, there is no doubt there is an abundance of money, although it is not in the hands of those who would spend it on goods/services included in the CPI-U basket. It is not a given that it eventually will find its way into those hands either. There could still be a relative shortage of goods/services, but productivity and occupation are both high. Maybe something like reduced flow of goods from abroad...

Clearly we are instead seeing "inflation" in the price of financial securities. That too is undeniable.

In short, to many dollars, chasing fewer goods. Inflation gone wild the headline will read.
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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by ray.james » Sat Feb 22, 2020 1:03 pm

SimpleGift wrote:
Sat Feb 22, 2020 10:38 am
ray.james wrote:
Fri Feb 21, 2020 5:35 pm
I am surprised how much smooth the inflation curve is compared to 10 yr yield.
Since the OP chart is comparing the annual yield of the 10-year Treasury bond against the 10-year average of the subsequent inflation rate, the inflation series appears much smoother.

The chart is just trying to show how the bond market's forecast of future inflation is often wildly inaccurate — and suggesting that investors not be lulled into thinking that today's low inflation regime will last forever and ever.
Ah, sorry missed that. I misread what subsequent meant; even though that makes more sense.
Last edited by ray.james on Sat Feb 22, 2020 1:07 pm, edited 1 time in total.
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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by ray.james » Sat Feb 22, 2020 1:06 pm

willthrill81 wrote:
Sat Feb 22, 2020 10:51 am
SimpleGift wrote:
Sat Feb 22, 2020 10:38 am
ray.james wrote:
Fri Feb 21, 2020 5:35 pm
I am surprised how much smooth the inflation curve is compared to 10 yr yield.
Since the OP chart is comparing the annual yield of the 10-year Treasury bond against the 10-year average of the subsequent inflation rate, the inflation series appears much smoother.

The chart is just trying to show how the bond market's forecast of future inflation is often wildly inaccurate — and suggesting that investors not be lulled into thinking that today's low inflation regime will last forever and ever.
That's why I really shake my head at all of those who turn their nose up at TIPS right now. The break-even inflation rate on 10 year TIPS right now is just 1.61%. There isn't much downside to that unless you believe that deflation has a meaningful chance of occurring.
Even if there is deflation, it will trail cash/CD by less than 0.5% :D
I guess current asset higher pricing across the board continues.
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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by Seasonal » Sat Feb 22, 2020 1:11 pm

Doc wrote:
Fri Feb 21, 2020 5:06 pm
SimpleGift wrote:
Thu Feb 20, 2020 6:24 pm
In theory, the buyer of a 10-year nominal bond should have an informed idea of the average inflation rate over the next 10 years. To test this theory,

...

Your thoughts?
Once upon a time there were comments I think here, that one of (or maybe the) reason for the introduction of TIPS was to get a market view of future inflation. I believe that idea has been long abandoned.
I believe the general view is that the nominal Treasury - TIPS spread represents a market view of future inflation, subject to adjustment based on liquidity differences and the price of inflation insurance. I could be wrong; why do you believe the view has been abandoned?

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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by Pierre Delecto » Sat Feb 22, 2020 1:12 pm

How can we know? Not trying to be flippant but we’d have to know the future.

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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by Seasonal » Sat Feb 22, 2020 1:20 pm

rustymutt wrote:
Sat Feb 22, 2020 10:51 am
Thesaints wrote:
Thu Feb 20, 2020 9:30 pm
Inflation is caused by a relative abundance of money available to be spent on goods/services included in whatever inflation measure is used, with respect to the abundance of those goods/services available to be exchanged.
At present, there is no doubt there is an abundance of money, although it is not in the hands of those who would spend it on goods/services included in the CPI-U basket. It is not a given that it eventually will find its way into those hands either. There could still be a relative shortage of goods/services, but productivity and occupation are both high. Maybe something like reduced flow of goods from abroad...

Clearly we are instead seeing "inflation" in the price of financial securities. That too is undeniable.

In short, to many dollars, chasing fewer goods. Inflation gone wild the headline will read.
An issue with that view is the quantity of base money increased dramatically following the financial crisis with no corresponding increase in inflation. Velocity of money is the key.

Velocity is a ratio of nominal GDP to a measure of the money supply (M1 or M2). It can be thought of as the rate of turnover in the money supply--that is, the number of times one dollar is used to purchase final goods and services included in GDP.

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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by willthrill81 » Sat Feb 22, 2020 1:58 pm

Seasonal wrote:
Sat Feb 22, 2020 1:20 pm
rustymutt wrote:
Sat Feb 22, 2020 10:51 am
Thesaints wrote:
Thu Feb 20, 2020 9:30 pm
Inflation is caused by a relative abundance of money available to be spent on goods/services included in whatever inflation measure is used, with respect to the abundance of those goods/services available to be exchanged.
At present, there is no doubt there is an abundance of money, although it is not in the hands of those who would spend it on goods/services included in the CPI-U basket. It is not a given that it eventually will find its way into those hands either. There could still be a relative shortage of goods/services, but productivity and occupation are both high. Maybe something like reduced flow of goods from abroad...

Clearly we are instead seeing "inflation" in the price of financial securities. That too is undeniable.

In short, to many dollars, chasing fewer goods. Inflation gone wild the headline will read.
An issue with that view is the quantity of base money increased dramatically following the financial crisis with no corresponding increase in inflation. Velocity of money is the key.
I have not dug into this myself, but my understanding is that the increased supply of money was more or less hoarded by banks who didn't want to get into another liquidity crunch the way they did in the GFC. As such, inflation never reared its head.
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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by Doc » Sat Feb 22, 2020 3:18 pm

Seasonal wrote:
Sat Feb 22, 2020 1:11 pm
Doc wrote:
Fri Feb 21, 2020 5:06 pm
SimpleGift wrote:
Thu Feb 20, 2020 6:24 pm
In theory, the buyer of a 10-year nominal bond should have an informed idea of the average inflation rate over the next 10 years. To test this theory,

...

Your thoughts?
Once upon a time there were comments I think here, that one of (or maybe the) reason for the introduction of TIPS was to get a market view of future inflation. I believe that idea has been long abandoned.
I believe the general view is that the nominal Treasury - TIPS spread represents a market view of future inflation, subject to adjustment based on liquidity differences and the price of inflation insurance. I could be wrong; why do you believe the view has been abandoned?
Wasn't me that reached that conclusion. It was many others. The problem is that the equation is not simply:

Inflation = Nominal Yield minus TIPS Yield

You have to also enter terms for an (unexpected) Inflation Protection factor and a TIPS illiquidity factor. And those two factors are unknowable. I belive what happened is that after we started to get enough TIPS data and do some backtesting it turned out that the original equation was not very good. But at the same time investors liked the TIPS for the unexpected inflation factor and the Fed keeps issuing them for us despite the fact that the original reason for them proved undependable.

If you belive that TIPS are just like nominals except for the inflation protection take a look at how TIPS and nominals performed in '08.
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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by Seasonal » Sat Feb 22, 2020 3:42 pm

willthrill81 wrote:
Sat Feb 22, 2020 1:58 pm
Seasonal wrote:
Sat Feb 22, 2020 1:20 pm
rustymutt wrote:
Sat Feb 22, 2020 10:51 am
Thesaints wrote:
Thu Feb 20, 2020 9:30 pm
Inflation is caused by a relative abundance of money available to be spent on goods/services included in whatever inflation measure is used, with respect to the abundance of those goods/services available to be exchanged.
At present, there is no doubt there is an abundance of money, although it is not in the hands of those who would spend it on goods/services included in the CPI-U basket. It is not a given that it eventually will find its way into those hands either. There could still be a relative shortage of goods/services, but productivity and occupation are both high. Maybe something like reduced flow of goods from abroad...

Clearly we are instead seeing "inflation" in the price of financial securities. That too is undeniable.

In short, to many dollars, chasing fewer goods. Inflation gone wild the headline will read.
An issue with that view is the quantity of base money increased dramatically following the financial crisis with no corresponding increase in inflation. Velocity of money is the key.
I have not dug into this myself, but my understanding is that the increased supply of money was more or less hoarded by banks who didn't want to get into another liquidity crunch the way they did in the GFC. As such, inflation never reared its head.
From what I've seen, the increase in base money far outweighed any increase in bank capital or other "hoarding". Banks usually hold as little as possible, since they make money by lending, etc. Do you have any statistics or other such data?

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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by willthrill81 » Sat Feb 22, 2020 3:53 pm

Seasonal wrote:
Sat Feb 22, 2020 3:42 pm
willthrill81 wrote:
Sat Feb 22, 2020 1:58 pm
Seasonal wrote:
Sat Feb 22, 2020 1:20 pm
rustymutt wrote:
Sat Feb 22, 2020 10:51 am
Thesaints wrote:
Thu Feb 20, 2020 9:30 pm
Inflation is caused by a relative abundance of money available to be spent on goods/services included in whatever inflation measure is used, with respect to the abundance of those goods/services available to be exchanged.
At present, there is no doubt there is an abundance of money, although it is not in the hands of those who would spend it on goods/services included in the CPI-U basket. It is not a given that it eventually will find its way into those hands either. There could still be a relative shortage of goods/services, but productivity and occupation are both high. Maybe something like reduced flow of goods from abroad...

Clearly we are instead seeing "inflation" in the price of financial securities. That too is undeniable.

In short, to many dollars, chasing fewer goods. Inflation gone wild the headline will read.
An issue with that view is the quantity of base money increased dramatically following the financial crisis with no corresponding increase in inflation. Velocity of money is the key.
I have not dug into this myself, but my understanding is that the increased supply of money was more or less hoarded by banks who didn't want to get into another liquidity crunch the way they did in the GFC. As such, inflation never reared its head.
From what I've seen, the increase in base money far outweighed any increase in bank capital or other "hoarding". Banks usually hold as little as possible, since they make money by lending, etc. Do you have any statistics or other such data?
I don't have any firm data on it, but it seems that any sizable reserves they may have had years ago have largely been exhausted. Repo rates are believed to have spiked last fall due to a shortage of bank reserves.

At any rate, the idea that the money supply growing faster than GDP results in inflation seems to have fallen far short of reality over the last decade.
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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by Seasonal » Sat Feb 22, 2020 3:53 pm

Doc wrote:
Sat Feb 22, 2020 3:18 pm
Seasonal wrote:
Sat Feb 22, 2020 1:11 pm
Doc wrote:
Fri Feb 21, 2020 5:06 pm
SimpleGift wrote:
Thu Feb 20, 2020 6:24 pm
In theory, the buyer of a 10-year nominal bond should have an informed idea of the average inflation rate over the next 10 years. To test this theory,

...

Your thoughts?
Once upon a time there were comments I think here, that one of (or maybe the) reason for the introduction of TIPS was to get a market view of future inflation. I believe that idea has been long abandoned.
I believe the general view is that the nominal Treasury - TIPS spread represents a market view of future inflation, subject to adjustment based on liquidity differences and the price of inflation insurance. I could be wrong; why do you believe the view has been abandoned?
Wasn't me that reached that conclusion. It was many others. The problem is that the equation is not simply:

Inflation = Nominal Yield minus TIPS Yield

You have to also enter terms for an (unexpected) Inflation Protection factor and a TIPS illiquidity factor. And those two factors are unknowable. I belive what happened is that after we started to get enough TIPS data and do some backtesting it turned out that the original equation was not very good. But at the same time investors liked the TIPS for the unexpected inflation factor and the Fed keeps issuing them for us despite the fact that the original reason for them proved undependable.

If you belive that TIPS are just like nominals except for the inflation protection take a look at how TIPS and nominals performed in '08.
Is there any substantive difference between the bold underlined in my post and in yours?

There have been some studies of these. While they can't be measured directly (so far as I know), they can be modeled. Here are two random examples, chosen solely based being on top of a google search. https://www.frbsf.org/economic-research ... 017-11.pdf and https://www.federalreserve.gov/econres/ ... 190521.htm

2008 was a flight to extreme liquidity. I bought some TIPS at very attractive prices at the time. It's not clear how generally applicable that situation was.

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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by Seasonal » Sat Feb 22, 2020 3:54 pm

willthrill81 wrote:
Sat Feb 22, 2020 3:53 pm
At any rate, the idea that the money supply growing faster than GDP results in inflation seems to have fallen far short of reality over the last decade.
Yes.

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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by willthrill81 » Sat Feb 22, 2020 4:22 pm

Seasonal wrote:
Sat Feb 22, 2020 3:54 pm
willthrill81 wrote:
Sat Feb 22, 2020 3:53 pm
At any rate, the idea that the money supply growing faster than GDP results in inflation seems to have fallen far short of reality over the last decade.
Yes.
I believe that this may be explained at least in part via consumer behavior: if consumers aren't expecting significant inflation, then they don't demand it on the labor market, and it never materializes, a sort of self-fulfilling prophecy.
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Re: Are Bond Yields Accurately Forecasting Future Inflation?

Post by Broken Man 1999 » Sat Feb 22, 2020 5:06 pm

No idea where inflation will go. I hope it remains in check, but hope isn't a strategy for our portfolio.

DW and I have a boatload of I-bonds, lots of Vanguard Short-term Treasury Index fund, and lots of Vanguard Intermediate-term Treasury Index fund, and a large, though decreasing amount of Vanguard Total Bond Index fund.

Overall desired AA is 50% equities/40% bonds/bond funds. Right now we are at 53% equities and 47% bonds/bond funds. I'll rebalance if/when equities reach 55%. I have been selling equities for expenses, but with the bill market our equity percentage is still growing. Though, if we give back a lot of the gains in equities, I might not reach a balancing band. Who knows, I sure don't.

I haven't succumbed to reaching for yield as some posters seem to be doing. I want only very high quality bonds/bond funds. I predict some will get burned in their quest for fixed-income investments that pay a bit more than treasuries. I am certainly losing some amount to inflation via my very conservative bond choices. But, I am OK with that.

We will know where inflation is going, but only when it is here, not in advance. Looks like clear sailing, but things like that can change on a dime.

Broken Man 1999
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