Making Sense Of Diverging Real And Nominal Treasury Yields

The US Treasury market is confused, or so it appears. While nominal yields have been rebounding recently, real (inflation-adjusted) rates keep falling, plumbing deeper into the sub-zero realm. One of these trends will eventually break and fall in line with the other. Which one will cry “uncle” first? The answer probably resides with how the incoming inflation data shakes out in the months ahead.

What’s clear now is that a divergence in yields has been unfolding recently, as shown by the nominal 10-year Treasury yield vs. its real-yield counterpart. For easier visual comparison the yields are converted into z-scores in the chart below.

The key takeaway: the two yields generally track each other, although not perfectly and at times there are relatively wide divergences. But the gaps are temporary and eventually the glue provided by market trading and the economic activity prevails. The challenge is that in real time it’s difficult if not impossible to know how and why the divergence will correct. Sometimes the real yield gives way and returns to a closer correlation with the nominal; other times it’s the reverse.

What will drive the convergence this time? Many factors, although incoming inflation data will likely be the main catalyst. The key question: Will inflation accelerate in 2021? The nominal 10-year yield is arguably front and center on expecting exactly that. After falling to just above 0.5% in 2020, the 10-year rate has been rebounding lately and is currently 1.05% (Jan. 26), which is close to the highest level since last spring.

The recent U-turn in the nominal 10-year rate is exhibiting strong upside momentum at the moment, based on a set of moving averages. This is a clear break with the downside trend that prevailed previously. Note, however, that the secular decline in interest rates that’s been in force since the 1980s periodically reverses before resuming its slide. No one knows if that long-running trend will again reassert itself. Incoming inflation data will probably determine the answer.

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Disclosure: None.

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