The Fed Should Be Dabbing Right Now

The 10-year yield on U.S. Treasury bonds has breached the psychologically important 3% level.  

The key question to ask is whether rate increases are likely to continue. The yield for any U.S. Treasury (UST) obligation can be broken down into four parts, ignoring the remote (for now) probability of default: a real yield required for letting the U.S. government borrow from us, a real term premium or discount for lending over a longer period of time instead of a shorter term, compensation for expected inflation over the term of the obligation, and a premium for the risk that inflation may be well above expectations.  

Since early 2014, the five-year forward real yield on a 1-year UST note has averaged 0.82%. The current level of 0.87% is little different. The term premium for holding a 10-year UST bond (five years forward) instead of 1-year note is now less than 0.10%, well below the median of 0.30% since early 2014. This reflects the fact that real yields on longer-dated UST obligations have been trending slightly lower in recent years. 

The expected inflation level is where the real action has been. Markets are now pricing in annual CPI inflation of approximately 2.2%, the highest mark since 2014 and well above the 1.8% level that prevailed this past fall. Interestingly, there is still little inflation risk premia on offer despite this jump in inflation expectations (at most 0.10% for 7-10 year notes, by our estimate).

This suggests the Federal Reserve deserves a gold star for keeping inflation expectations so well moored to the 2-2.5% level. Inflation is a psychological phenomenon, not the mechanical one that’s often portrayed. By getting inflation expectations back above 2% without causing fear of even higher inflation (again, no inflation risk premia), the Fed has pulled off quite a feat. Since inflation expectations are on track, higher rates from here will likely require a step up in real yields.  

Higher real yields require a change in global savings and investment dynamics. Real yields are historically low, but unless there is a material shift in global behavior, such as a plunging savings rate in China, there is little reason to expect much change. We expect near-term interest rate movements will be limited to Fed Funds rate policy normalization, meaning slightly higher yields for short-term paper, but little additional change for longer-term bonds.

Disclosure: None.

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