Inflation Adjusted Bond Prices Tell Different Story on Relative Value

EconMatters's picture

By EconMatters  



One of the arguments for why US Bonds are such an attractive investment even at these low yields is that relative to European Bonds the US Treasuries provide such a higher yield, but this analysis is shortsighted because it fails to take into account the factor of inflation. Once you adjust yields based upon inflation it tells investors an entirely different story in regards to relative value of bonds and the comparison is different between European and US Bonds. 


For example take the German 10-Year bond at 1.15% Yield versus the US 10-Year Bond with a yield of 2.47%; well the argument goes why would I invest in the German Bond relative to the US Bond when the yield is so much greater? But investors need to remember to factor in inflation levels, so the German yield minus Eurozone annual inflation of 0.4%, remember it isn`t Germany`s inflation which is higher but still under 1% annualized, it is the Eurozone since they share the currency of the Euro that is important here, so we get 1.15% minus 0.4% for an inflation adjusted yield of 0.75% or 75 basis points. Now contrast the US 10-Year Bond with a Yield of 2.47% minus an annual inflation rate of 2.1% and we get an inflation adjusted yield of 0.37% yield or 37 basis points.

Under this analysis the German 10-Year inflation adjusted yield is 38 more basis points than the US equivalent 10-year, so this throws a bunch of cold water on the notion that US Treasuries are such a yield bargain for investors compared to European bonds. 


In fact, considering the US inflation rate is probably much higher than the numbers are actually detailing in the watered down inflation metrics used to track inflation by the government due to a number of factors, and it is rising on an upward trend the US 10-Year yield probably needs to rise against the German 10-year, as it is even more out of whack once you factor in the future growth prospects of the two economies. 


So as the previous theory went regarding relative value of the two bonds, and the trade being to short German bonds [short price long yield] and buy US bonds [long price and short yield] on a spread trade. Actually if we were going by the inflation adjusted return fundamentals we should be shorting US Bonds [short price long yield] and Buying German Bonds [long price short yield] for a spread arbitrage yield value trade. Remember yields go in the opposite direction of bond prices to fully wrap your head around the trade. 

I don`t recommend this as theory is different in financial markets than making money, but this hypothetical spread trade was just to illustrate how investors often choose investment vehicles or make trades based upon faulty assumptions, and once one accounts for inflation, there are a lot of investors talking about relational values of bonds that are actually the exact opposite of what rationale they are using to base their investment decisions. 


Therefore, by my calculation the US 10-YEAR Yield is not that attractive relative to European Bond Yields, in fact US bonds are downright expensive in terms of price versus the inflation adjusted yield I am getting as an investor. Remember one has to invest using the same currency that the bonds are purchased in, and thus inflation adjusted returns matter in this case when evaluating relative value and real returns.



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Downtoolong's picture

Interesting analysis and argument.


If you’re an individual investor who is spending their earnings to survive, you likely don’t have a choice what inflation you are subject to. (I can’t fly to Frankfurt to buy food and gasoline for my car if I live in Miami)

You also need to consider the tax rate bite on the paltry income you earn from these investments which is also dictated by location.

One you factor that into the analysis, along with the fact that inflation statistics (especially in the U.S.) are all phony anyway, you realize that no matter what you do your real earnings on 10Y bond investments are zero at best and you ask, “Why should I even waste my time thinking about investing in this horse shit financial market instead of going fishing?”.  



oudinot's picture

I believe this argument is spurious.

The relative inflation of Sovereign bonds  is discounted in the relative currency value.


himaroid's picture

You are not considering these nice cap gains on treasuries. Also inflation is self defeating. Nice TLT dividend this week to be reinvested in.....TLT!

Bossman1967's picture

What does inflation n Germany have to do with the yield that I make. I liv in he US and I live under this a2.1 percent inflation not german! Are there people out there that would buy that crap both in how Germany inflation would help my USA net interest rate that is realized and 2.1 my ass. Where do they come up with these numbers. The real world says much much more. Maybe if they came out with the real numbers more people would wake up and do something about this joke of an economy. Lies lies and more lies.

AdvancingTime's picture

 It might soon become apparent the economic efficiency of credit is beginning to collapse and the additional money poured into the system coupled with lower rates can no longer drive the economy forward.  When this happens we are at the end game.

At some point the return on loaning money is simply not worth the risk!  Why do you want to loan money if most likely you will never be repaid or repaid with something that is totally worthless? When this happens the only safe place to store wealth will be in "tangible assets" and the only lenders will be those who print the money that nobody wants.

The collapse of credit can pose major problems such as what we saw when many sellers were forced to demand payment up front before shipping goods in 2008. More on this subject below.


ebworthen's picture

All those folks looking at their 401K/IRA/Pension statements thinking "Wow, I might be o.k. after all."

Don't hold your breath, folks.  The Wall Street/Washington cabal will crash this puppy again, on purpose.

It will be a "tragedy" that will require "extreme measures" of one kind or another - "no one saw this coming" and "tanks in the streets if we don't do something!"  Bail-ins, cram downs, increased taxes, confiscation.

And they will do everything OTHER than make you whole again; you all are the marks, the dupes, for believing.

You have been warned.

NidStyles's picture

Had this girl bragging about having 20K saved in her 401K. I gave her a chuckle and reminded her that she would have to pull that money out for it to actually be hers. She was not happy...

MalteseFalcon's picture

You're right. She should have forgone any company match and spent it

ThroxxOfVron's picture

This was a good start; but, there is a hell of a lot more to weigh when considering investment foreign bonds.  

Neither the costs of converting dollars to and from euros to purchase euro denominated Bunds or the variances in the currency crosses that might render yield insufficient even if currency conversion does not devour coupon are considered.

Consider also that IF the Euro breaks up and the Nordic/Germanic block is left with the Euro a Euro appreciation might occour drastically altering the Euro/Dollar cross and thus the coupon and principal as denominated.  Germany could also decree the reciprocal -that denomination of Bunds is just what they will be paid back in, rendering legacy Bunds denominated in Euros paid in a seriously depreciated currency cheaply obtainable by Germany trading strong 'NeuDM' for Euros to satisfy the debt with the arb advantage..  

hedgiex's picture

Yes. The assumption of the article is that the other parts of the economy are benign or relatively static; some of which you have pointed out.

In the real world of trading today, when global traders execute their ideas, they are paranoid over liquidity risks that close exits. Many of these ideas do not fly when market sectors go illiquid.

This article propounds one of the thousand of trade ideas flying each day in rigged markets, rigged data (inflation), printing presses and bankster captive front runs. It smacks of the deadly theories that come out of all things being equal, this will be the case.l

It is street fights not umpired games.

exartizo's picture

excellent bond anlalysis. well written.

EndOfDayExit's picture

The problem with 10-year bonds is that no one can tell what inflation is going to be over the next 10 years.

0b1knob's picture

The problem with 10-year bonds is that no one can tell if the US will still exist in 10 years.

disabledvet's picture

Well, if the response to 2008 is any answer "the USA might not exist in ten years but the ten year treasury note will do just fine!"

Here's a simple both sides of the Atlantic calculate inflation the same way? (Meaning THE WRONG WAY) because if so....aww, forget it. I hate myself whenever I read this clown.

Again...HUGE production explosion in the USA of pretty much EVERYTHING. The dollar remains well nigh worthless, the Fed will not be tightening for the next century, a thirty thousand man Russian Army might scare Ukraine but not NATO. I have no clue what Israel is doing....but whatever it is "that costs extra now."

Energy COSTS have COLLAPSED in the USA. You might as well be trying to whistle when the eyewall of Hurricane Andrew hit South Florida betting against the Fed here.

Interest rates have nowhere to go but down...defaults on the other hand are going to friggin moonshot....especially in Europe. THERE IS NO CARRY OVER THERE. Name on thing they make over there that cannot be Made in China (besides debt of course.)

NidStyles's picture

Energy costs have not collapsed in the US, and saying they have is borderline delusional.


What has collapsed though is the demand for said energy. The rest of your post was based on that faulty premise and is thusly invalid. You're obviously one of the pro-propagandists agreeing with US energy independence. If only such things were realistic.

MalteseFalcon's picture

Gasoline demand has been going down in the US since the middle of the last decade.  Demand has gone up elsewhere in the world, it's a global market, so the price of gasoline does not go down.  Or so they tell me.

This assumes that this market isn't rigged.  Unpossible.

Bossman1967's picture

Consumption down because price even at 3.00 gallon is not affordable to at least the 50 percent Obama suckers. Unless they also get an Obama gas card. Was wondering how many people can afford to even crank their car much less afford the car