The Great Divergence: Nominal Vs. Real Treasury Yields

The Treasury market’s implied inflation forecast continues to rise, but the source of this reflationary trend is born of a growing divergence between nominal and real (inflation-adjusted) Treasury yields. Explaining the divergence and pondering the implications can take several paths. But no matter your preference, all roads begin with monitoring the data that highlights this expanding gap.

The first point to note: the spread between nominal less inflation-indexed Treasury rates continues to rise – an increase that many analysts cite as a key indicator for the revival in reflation sentiment. The spread for 5-year maturities, for example, edged up yesterday (Feb. 8) to 2.31 percentage points, an 8-year high.

The key driver for this reflationary trend is primarily due to an ongoing slide in the real Treasury yield, supported by a relatively mild rise (so far) in the nominal yield. Here’s how the rates for 5-year maturities compare since 2017. Note the expanding divergence over the past year:

For a clearer visual comparison, let’s transform the 5-year yields into z-scores, which measure standard deviations from the mean:

Prior to the pandemic, the nominal and real 5-year yields were closely correlated. Over the last year, however, the relationship broke down. Clearly, the coronavirus crisis has altered the relationship. It’s unclear if this is a temporary or permanent change, but for the moment it’s significant, and increasingly so, thanks mostly to a real yield that’s dropping like a stone.

Untangling the underlying economic logic is a work in progress, but there are several possibilities to consider. One is that the yield divergence reflects investor confidence that the Fed will keep inflation under control, supported by secular disinflationary forces. The central bank has recently announced that it will allow pricing pressure to run hot above its 2% target for a period of time, but the crowd appears to be convinced that materially higher levels of inflation remain a low-probability scenario.

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