IN 2005 THENFederal Reserve chairman Alan
Greenspan mused about the conundrum of low
long-term U.S. Treasury yields in the face of a rising federal
funds rate. Today many analysts are again baffled by low bond
yields, this time citing two different conundrums.
Bond yields could not possibly remain so low relative to
equity earnings yields and dividend yields, people say. Nor
could recent bond yields possibly make sense in light of
current inflation levels, they say. But neither of these
assertions holds water when examined with proper perspective.
On the contrary, Treasury yields are likely to remain low for
years, although brief rises are certainly possible. Moreover,
new lows in Treasury yields probably still lie ahead.
Consider the first conundrum: the current relationship of
Treasury yields to equity and dividend yields. In both the
third and fourth quarters of 2011, the earnings yield on the
Standard & Poors 500 Index was more than 2.5 times
the composite long-term government bond yield, by far the
biggest multiple in the past 50 years. And in the fourth
quarter, the dividend yield on the S&P 500 (2.13 percent)
was only barely below the composite long-term government bond
yield (2.7 percent) the narrowest gap in decades. These
facts are cited as reasons that bonds have been overpriced.
Yet the complete historical record shows that the current
relationship of earnings yields to Treasury bond yields is
hardly unprecedented. The ratio has been far higher in the past
and has stayed above current levels for long periods. The
comparison of bond yields to dividend yields over the past 130
years paints a similar picture, with todays bond yields
appearing not all that unusual.
The return of the earnings-yield-to-Treasury-yield ratio to
levels that existed before 1960 is highly consistent with a
unique characteristic of the past four years: the reversal of
U.S. private sector balance-sheet expansion. From the end of
World War II through 2007, private sector balance sheets (both
assets and liabilities) generally expanded faster than incomes,
reflecting rising leverage and the accompanying inflation in
asset values. As the asset appreciation came to be gradually
embedded in expectations, investors demanded less current yield
from equities relative to bonds.
Since 2008 debt has contracted and asset valuations have
been on a secular decline. Investors priorities have
shifted toward preserving capital and away from chasing asset
appreciation. This shift is reflected in the low yield on
Treasury Inflation-Protected Securities and in the high rental
yield on real estate relative to government bond yields.
Investors are highly averse to taking losses, let alone to
paying a premium for prospective appreciation. It is hardly
surprising that equity yields have risen sharply in relation to
The second apparent conundrum cited by bond skeptics is that
investors have been willing to accept a negative real return on
Treasuries. In early 2012 the monthly average ten-year TIPS
yield was negative for the first time ever, inciting cries that
Treasury bonds (both TIPS and regular Treasuries) were in
bubble territory. However, such low real yields are
in fact not so surprising, and nominal yields are likely to
Consider the outlook for Treasury yields this way: From
spring 2011 to early 2012, the decline in the ten-year Treasury
nominal yield from 3.5 percent to 2 percent was driven
primarily by increased demand for Treasuries as a safe asset,
not by falling inflation expectations. Think of the nominal
yield as being the sum of two components the real yield
and inflation expectations. Taking the TIPS yield as a rough
proxy for the real yield, the decline in the real yield
component accounted for more than two thirds of the total
nominal yield decline.
Clearly, a major reason for the decline in real yields is
that the pool of safe assets in the world has
shrunk while the demand for them has broadly continued to grow.
Central bank asset purchases and downgrades of structured
securities and European sovereign debt together have eliminated
a huge pool of safe assets.
Looking ahead, real yields appear likely to resist upward
pressure. The pool of safe assets will remain shrunk. Although
the perceived riskiness of European sovereign debt will vary
somewhat, the taint on these formerly ironclad securities is
unlikely to vanish for a long time.
Meanwhile, inflation expectations are likely to fall over
the course of the next year. Disinflationary pressures in the
economy most notably, the downward pressure on wage
inflation from high unemployment will remain strong.
Additionally, perceptions of economic strength are likely to
weaken as 2012 progresses.