Beware of the bubble in bonds

(Fortune) -- Here we go again. In just six weeks the prices of U.S. Treasuries have soared, sending the yields on the 10-year bond from 4% back to 3.2%, close to their levels when terror reigned early last year. Don't let Wall Street's cheerleaders convince you that the sudden drop in the cost of borrowing heralds a new era of moderate inflation that will keep Treasury prices aloft, and interest rates low, for years to come.

On the contrary, in a volatile era when little about our economic future is certain, one thing couldn't be more obvious: Treasuries are forming still another outrageous, treacherous bubble. "We're seeing a flight to safety that cannot last, and it's bringing back the 'greater fool theory,' " charges Allan Meltzer, the distinguished monetarist at Carnegie Mellon. "Investors believe they can unload those bonds at higher prices to someone else. Remember, those same bonds yielded 4% last month. They will be forced to sell those Treasuries at a big loss."

Let's take time to analyze why a 3.2% Treasury yield is totally unsustainable, especially in the spreading shadow of inflation. Those yields comprise two parts: The "real rate" of interest and the "inflation premium." Corporate bonds have a third metric, the "risk premium," or an extra yield to compensate for the chance of a default -- it's big for junk bonds and narrow for top corporates. For Treasuries the risk of nonpayment is virtually zero, leaving just the first two factors.

Risk factors

That doesn't mean that Treasuries aren't risky. Far from it. Both the inflation premium and the real rate can change swiftly and sharply, as we're seeing right now. The reason is that they depend on investors' vision of the future, a view that can shift from optimism to fear in a hurry. Right now, the problem is that both the inflation premium and the real rate are far too low.

Let's start with the real rate. The best measure is the yield on TIPS, which automatically compensates investors for inflation with an extra payment, so that their rates reflect what investors demand over and above the CPI. Right now, the yield on 10-year TIPS -- or the real rate -- is a minuscule 1.25%.

That leaves an inflation premium of less than 2% (the 3.2% yield minus the 1.25% real rate), meaning investors expect that for the ten years they hold that Treasury, prices will rise less than two points a year.

Neither today's real rate nor the cushion for future inflation is remotely reasonable, for two reasons. First, both are far below any historical measure, which is always a danger signal. Second, given perils ranging from huge deficits to an exploding money supply, they should be far higher than normal, not lower. Getting back not just to normal, but to beyond normal won't be pleasant.

Over long periods the yield on the Treasuries tends to track growth in real GDP, plus inflation. Over the past 20 years, for example, the rate on the 10-year has averaged 5.5%, about evenly divided between the real rate and the inflation premium. That's close to economic growth of 4.9%.

So why are yields now sitting a full 2.3 points below their historical levels? A major factor is the expansionary policy of the Federal Reserve. "When the Fed holds short-term rates at close to zero, it also restrains longer-term rates," explains Brian Wesbury, chief economist at First Trust Advisors. "The Fed funds rate is the anchor, and that holds the boat, the long-term rate, on a short line." The second explanation is the recent flight to the safest dollar investments -- that's Treasuries -- following the debt crises in Greece and Spain that sent global investors fleeing the euro.

Both trends are temporary. Right now the rate of inflation is indeed low. The CPI is growing at just 2.2% on an annualized basis. But even today's official rate is understated. The recent decline is strictly the result of a fall in a measure called "owner equivalent rents," homeowners' estimates of what their homes would rent for. Those numbers suffer from long lags; rents dropped dramatically with the fall in housing prices, but they've now stabilized, so the trailing numbers give a false picture of true inflation. "Inflation for everything else is 3%," says Wesbury. "That's a far more realistic number."

Future inflation is the villain

And remember, Treasury yields depend not on current inflation, but on how investors predict its future trend. That trend is bound to push rapidly upward. "The Fed has stuffed the banks with $1 trillion in reserves," says Meltzer. "When they start lending again, inflation and rates will rise rapidly." Nor can real rates remain at today's depressed levels. If the economy keeps growing in the 3% to 4% range, real rates will rise with the increased demand for capital that recoveries inevitably bring.

So how high will yields go, and when will it happen? It won't happen soon. The Fed promises to hold rates extremely low "for the foreseeable future." The soonest that rates could rise substantially would be early next year. The real danger is that they could jump far above their 5.5% average. The prospect of future inflation is the villain -- both its revival and the uncertainty over how high it will eventually go. "We have a combination of giant deficits that the government has no solution for, and big monetary growth," says Meltzer. He predicts that inflation will rise well above its average of 2.5% to 3% a year.

And the real rate could also go far above the norm of 3% or so. Again, the problem is the uncertainty over future inflation. The same fears that plague stocks when their labor and materials prices suddenly soar also strike bonds. Investors then demand a bigger "real yield" because of the threat that surging inflation will swamp the piddling returns they're getting on their Treasuries.

Both Meltzer and Wesbury predict that rates will eventually go far above 6%. So what happens if you buy 10-year Treasuries today, and 24 months from now the yield rises from the current 3.2% to 6%? If you sell, you'll lose 18% of your money. The $10,000 you pay today will be worth just $8,200. The puny $320 a year you collect in interest will leave you with returns far below the rate of inflation. Smart investors who wait will collect $600 a year, or 6%, almost twice what you're pocketing.

We're facing a new era all right. And today's overpriced Treasuries send all the wrong signals by promising safety that's peril in disguise. They're about as safe as tech stocks in 2000, and we all know how that bubble turned to rubble.