When Bernanke delivered this sermon, the inflation rate was 2.2% (1.1% today), the core inflation rate was 2.0% (+0.9% today) and the unemployment rate was 5.8% (9.5% today). With that in mind, the case for more bond buying is actually pretty strong. And, if we do end up going to 2.5% on the long bond with the help of Helicopter Ben, that would imply a total return of well over 30%. It has taken the stock market nearly 13 years to achieve that result!
Also recall Ben Bernanke’s pledge at Milton Friedman’s 90th birthday on November 8, 2002:
“I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”
Buying more Treasuries at some point, perhaps not that far off in the distance, is still in the policy arsenal and as such, today’s near-4% yield in the long bond is going to look a whole lot like the 5% yield back in the summer of 2007, the 6% yield in the spring of 2000 and the 7% yield back in the fall of 1996 — a bargain.
You can see this across the yield curve as the 2-year note converges on Fed funds; the 5-year note on the 2-year note; the 10-year note on the 5-year note; and the long bond on the 10-year. Every segment of the curve will be flatter when this thing is over, and when it is over, yields across the curve will be at stupid-low levels. What sort of levels? Well, consider that in the past decade, the average spread between the 10-year note yield and Fed funds is 160 basis points; between the long bond and Fed funds is 210 basis points; and between the long bond and 10-year note, the spread has averaged 50bps (it is 125bps today!).
No matter how many bonds the Fed buys, it came out emphatically this week and said that economic conditions are “likely to warrant exceptionally low levels of the federal funds rate for an extended period.” And, there is no more powerful a variable in influencing the direction in bond yields than Fed policy — it commands an 88% correlation versus 75% for core inflation and 40% for budgetary deficits. When you look at what the yield curve will look like at the yield lows, a move to a 1.5-2.0% range on the 10-year note and 2.0-2.5% on the long bond is completely achievable, as crazy as this may sound.
Bernanke bought bonds in 2009 and yields still backed up because of a V-shaped inventory- and policy-induced recovery in the economy and an 80% bounce in the equity market off the lows. Even with that, the yield on the 10-year could never manage to break above 4%. But now the peak in the fiscal stimulus is behind us, the peak in the inventory cycle is behind us, the peak in growth is behind us, and a very uncertain economic landscape confronts us and the Fed is the only game in town but with all its bullets shot in terms of the funds rate. So, Bernanke et al are now going to be increasingly targeting longer-term interest rates as a means to revive growth, mitigate double-dip risks and avoid a potentially destabilizing deflationary experience – a “thin tail” event, perhaps, but one that carries with it a higher economic cost than the Fed Chairman is willing to bear.
If you think that it is completely nutty to think that yields cannot go to microscopic levels, even with large-scale government debts, then consider that in the past, at the peak of bull markets in bonds (the ultimate lows in yields), the curve gets so flat that the average spread between the long bond and Fed funds is 100 bps (and 25bps between long bonds and 10-year notes). It would seem that just as the BB sliver in the corporate bond universe was the laggard with the greatest return potential, within the Treasury curve (Canada curve too since the long end trades more off the U.S. rate structure than what the Bank of Canada does ... or doesn’t do) it would seem that the long end (again, the laggard) carries with it the most compelling total return opportunity (inflation expectations are still far too high).
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