Bond Bubble or Deflation?

With the 10 yr. U.S. Treasury bond yielding only 2.74%, there is talk of a bond bubble. Since bond prices move in the opposite direction of interest rates, bond prices have gotten rather heady. But this rate may be better than it seems and the bubble talk may be a bit premature.

In July the core (excluding food and energy – who buys that stuff?) inflation rate as measured by the Consumer Price Index (CPI) was at an annualized rate of 1.2% according to the U.S. Dept. of Labor. That would indicate that the real, inflation-adjusted yield on the 10 yr. is a puny 1.54%. But, as always, the devil is in the details, in this case, the way the CPI is computed.

Housing costs make up 40% of the core CPI, probably not unreasonable for the average family (remember, that’s after food and energy). The problem is in the way the government calculates housing costs. It uses the rental value of houses instead of a factor of price and mortgage rates, even though 67% of Americans own their homes.

Everyone knows that house prices generally have fallen significantly almost everywhere, some places as much as 50%. At the same time mortgage rates have dropped from about 6.5% to 4.5, a drop of 30%. According to an article in the August issue of Money Magazine (p. 35), since 2005 average rents have increased 11% while average home prices have dropped 30%.

The exact calculation calls for mathematical skills beyond my grasp, but, clearly, the largest component of the CPI has been rather seriously overstated, meaning that the Index is significantly overstated. Hence, we probably have slightly negative CPI, which means that real interest rates are higher than the nominal, or stated, rate.

The good news for those with cash is that you’re doing better than you thought because the purchasing power of your money is holding steady or even increasing. The bad news for the economy as a whole is that we may already be in the early stages of a deflation, a period of declining prices. When a deflationary psychology takes hold, people tend to hoard cash waiting for prices to fall further. The resulting decreased demand often leads to high unemployment and a hard-to-arrest downward economic spiral.