The third component

So far we have looked at relative nominal returns. As mentioned, money will flow to the highest real return, which means the nominal yield minus the expected rate of inflation. Economists and analysts have fiddled around for years trying to depict expected inflation and incorporating inflation forecasts into their estimate of the real return. In late October the inflation rate in the U.S. was about 3 percent and the inflation rate in Europe was about 2 percent. And as noted in the yield-curve discussion, the market had confidence in the will of the European Central Bank to restrain inflation, more so than its faith in the Fed on the same point. It’s not that Greenspan is more tolerant of inflation — such an idea would set his socks on fire — it’s that he has a mandate to promote growth, too.

In the current environment, beset by oil price shocks, both central banks are curve on the prospect of slower growth, but at some point they may be shocked into raising the long end of the yield curve to reflect higher inflation expectations in the U.S. And while both yield curves could show a lift at the
long end, the U.S. curve may not rise enough at the long end to make up for every expectation.

Assuming the European curve rises by less, a function of confidence in the ECB, European bonds may still be preferable on a real-return basis. Never mind Europe’s slow growth and institutional problems — to the bond investor, the real return and the steadiness of the return are as important as the actual level of return.