The performance of 10-year T-notes during deflation

In our previous article we presented a prediction of an extended period of price deflation in the U.S. since 2012. Our projection was made in 2006 and covers the period between 2006 and 2016. At least five years are characterized by negative inflation. The underlying model can also foresee beyond 2016 when some updated labour force projections are used (see Appendix). There is no expectation of a positive inflation rate at least in the 2010s. Deflation is a major risk for the U.S. economy and stock market. Therefore, one can consider a safer investment in Treasuries. Let us check various options. 

Currently (August 18, 2:15), T-notes and T-bonds have very low yields between 0.19% for 2-year T-notes and 3.55% for 30-year T-bonds. Since the predicted deflationary period will last at least 8-years one can choose between 7-year and 10-year T-notes. The former has the yield of 1.45% and the latter 2.15% (coupon 2.125%). Taking into account the predicted rate of inflation below -0.5% per year in the near future, one can evaluate the real yield as 3% in the next few years. This is a safe and relatively profitable investment during the poor years to come. The stock market will likely be stangnant if not  decaying.

 Appendix

The BLS has projected the level of labour force to increase from 154.300.00 in 2008 to 167.000.00 in 2018, i.e. by 0.8% per year on average. Considering the current fall in the rate of participation down to 64.5% (instead of 66%) which was expected only in 2018, we should decrease the projected level in 2018 by approximately 1.2%, i.e. to 165.000.000. Then, the rate of labour force growth is 0.66% on average between 2008 and 2018. According to our model the rate of consumer price inflation is driven by the change rate in labour force: 

CPI(t)=4.5dlnLF(t-3)/dt - 0.032 (1) 

where CPI(t) is the rate of consumer price inflation at time t, LF(t-3) is the level of labour force three years before the predicted rate of inflation. Using the average rate of labour force change between 2008 and 2018 one can estimate the average consumer price inflation between 2008 and 2018 as -0.3% per year. Since the years between 2008 and 2011 have a positive inflation rate the years after 2012 will have evens a smaller average inflation rate.  On average, I would estimate the future rate of inflation as -0.5% per year since 2012. However, during 2012 and 2013 it can be as low as -3%.