US Treasury Market Bubble

US Treasury Market “Bubble” – Given the extent of the recent US Treasury market rally on the heels of 2 Fed eases, precipitated by subprime loan problems, credit market seizures, and equity market contraction, the rally appears from most perspectives as being heavily overdone. The following 2 charts take a look at current market yields in an attempt to measure returns against a backdrop of rate expectations.

The bond market has several forecasting indicators that predict market yields. Some are the result of actively traded markets, while some are the median predictions of trained analysts and economists. At present, over roughly the next 2 years, current US Treasury market yields are all below market indicators that forecast where yields should be. Particularly in the short-end of the Treasury curve, Treasury yields are currently driven by an extraordinary flight-to-quality trade where investors facing losses in equities, mortgages, commercial paper, currencies, and other markets, have forsaken their risks and bought US Treasuries as a security measure. In bonds, excessive demand drives yields down. At present, US Treasury yields are very rich and potentially don’t even cover the cost of inflation rates, meaning the market’s “take-home” yield is actually negative.

Another method to measure if current market yields are attractive is to compare yields against inflation. The following chart details this comparison.

The chart above points to a distressing fact in today’s market, where investors are oblivious to the negative effects of inflation. Next week’s release of CPI is expected to show a current inflation rate of 3.5%. Deducting CPI’s cost against current market yields either totally eats up the return or leaves very little left over. The root cause of this is excess demand in Treasuries as a haven for risk in other areas. However, it appears investors are ignoring the most important risk to bonds – the risk of inflation.