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Wednesday, August 4, 2010

Those Low Treasury May Not Be So Irrational.

...Certainly with the new conventional wisdom decidedly in the deflation camp (as reported in the wsj).

That's in contrast with the warnings of high inflation that reflected conventional wisdom as recently as a few months ago because the fed was "flooding" the markets wtih liquidity. . As I pointed out then those folks should have reviewed their Friedman (the nobel prize winning economist stuff not the social criticicism. If they did they would know that if money supply is increased but there is no velocity (i.e. the money isnt let out. There will be no inflation. Keynes was aware of this too of course he coined the phrase pushing on a string. No wonder the fed is examining alternative ways to use monetary policy to stimulate the economy.

So if the treasury market is trading off a forecast of zero inflation or even deflation that 2.88% level on the 30 year bond doesn't look crazy for traders even if it would be a not very good purchase to put in the drawer for 30 years. A reasonable long term expectation fot the long bond is around 3% above inflation so the current yield is in line with historical rates.

Unortunately the low yields don't bode well for stocks, at least using one common methodology. Those that "bootstap" a long term forecast for stock returns a common academic finance approach  use  a long term risk premium for stocks (the compesation for taking on the additional risk of stocks) as 3 -4% over the risk free rate. That risk free rate could be the tbill rate of .16% or perhaps the 2 year note rate of .51%. That puts the expectation for stocks in the 3.5% to 4% range purely as a function of the current low level of interest rates.