To have long-term Treasury bonds above 6% when inflation is virtually nil is astonishing.
It works like this: the Fed buys long-term treasury bonds (which currently have a higher interest rate) rather than short-term ones.
In normal circumstances, one could help protect a portfolio by owning more long-term Treasury bonds, which often rise in value when stocks fall.
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Specifically, economists and traders will be looking to see if the Fed announces a new form of stimulus, such as buying long-term Treasury bonds.
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The Federal Reserve completed its daily purchase of U.S. long-term Treasury bonds Monday, sending Treasury bond prices up and yields down from the morning's levels.
The last time long-term Treasury bonds yielded 2.1% was in 1949.
Each year, I analyze the primary drivers of asset class long-term returns including risk as measured by implied volatility, expected earnings growth based on GDP estimates and foreign business expansion, market implied inflation based on the spread between long-term Treasury Bonds and TIPS, and current cash payouts from interest and dividends on bond and stock indexes.
This was due primarily to the narrowing spread between long-term 30 year Treasury Bonds and 30-year TIPS. The average spread has decreased from 2.8 percent during 2010 down to 2.5 percent in 2011.
FORBES: The Portfolio Solutions 30-Year Market Forecast for 2012
The market is pegging 30-year inflation at a slightly higher 2.0 percent rate, which is the spread between long-term 30-year Treasury nominal bonds and 30-year TIPS. Federal Reserve policy to increase the money supply has not led to inflation during this recovery because the demand for money has been lower than in other recoveries when inflation did occur.
FORBES: Portfolio Solutions' 30-Year Market Forecast for Investment Planning (2013 edition)
Under the new approach, the Fed would print new money to buy long-term mortgage or Treasury bonds but effectively tie up the money by borrowing it back for short periods at low rates.
For example, from January 1, 1926-July 31, 2012, long-term government bonds returned 5.77% annualized compared to 5.36% for five-year US Treasury notes but the long-term bonds had nearly double the volatility (Source: Ibbotson and Sinquefield).
In this hypothetical scenario 20% of the portfolio is invested in domestic large-cap growth, 10% in domestic large-cap value, 20% in domestic small-cap value, 10% in international equities, 25% in five-year U.S. Treasury notes and 15% in domestic long-term corporate bonds.
But the tax has had unintended consequences: the treasury is now struggling to find buyers for long-term bonds, which tend to be popular with foreigners.
According to the Deutsche Bank Long-Term Asset Return Study, the last time interest rates were near current levels, in the 1950s, Treasury bonds lost 40% of their inflation-adjusted value over the following three decades.
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