What’s the “right” price for 10-year Treasury bonds?

There’s a practical rule of thumb that has worked over many markets and many periods of time about expected returns for stocks, government bonds and cash.  It is:

stocks return inflation + 6% annually;

(long-dated) government bonds return inflation + 3% annually; and

cash returns inflation + (maybe) 1% annually.

In the absence of any specific insight about the current period (for example, I think stock returns will be higher than this rule implies over the next year or two), this is a reasonable starting point for a projection.

If the long bond is the 30-year, and if inflation will on average be 2% over the life of the bond, then the yield should be about 5%.

For the ten-year, the yield should be around 4%.

For cash, a “normal” yield should be around 2%. We know, though, that the Fed has made short rates as strongly negative in real terms as it can, because of the financial crisis.

Why, then, would ten-year yields have been close to 2% in late December 2008 and again in mid-January?  Panic.  You might also argue that the market was anticipating that the Fed would initiate its “quantitative easing” program to stimulate economic activity by holding down the price of longer-dated bonds.

If we take the rule of thumb for the 10-year as valid, then the idea that yields have risen to the current 3.50% or so because of inflation fears, as some commentators have suggested, makes no sense.  The truly extraordinary period was around the turn of the year, when yields were approaching 2%.

The move above 3% was, it seems to me, the removal of the 3% cap from the Fed’s promise to buy bonds to keep yields low.  I take this a good news, that the Fed thinks that unusual measure is no longer needed.

The yield on the 10-year would have to rise another 50 basis points for the market to be back to its typical trading level.

It’s also interesting to note that the stock market has taken the rise in yields in stride, suggesting that a benign interpretation of the move is the correct one.

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