US yields: Where the music plays

After reflation, stagflation? While in the real economy the “Grand Reopening”  party has just started, bond markets are seemingly positioned for a prolonged stagflationary scenario. Headline CPI reached 5% y/y in May but yields retreated. Even at a long-term horizon, a substantial inflation discount seems to be priced in, with 10y breakeven inflation at 2.4%. At the same time, the real yield remains deeply negative at -0.9%, suggesting a subdued long-term economic outlook. Market expectations seem to be skeptical about the Fed’s recovery narrative. It seems that we are once again witnessing a battle of expectations between markets and the Fed. This usually creates an unstable equilibrium prone to adrupt adjustments. But what if expectations do not diverge at all and other factors are behind this situation?

Repeat after me: Breakeven inflation is not expected long-term inflation. To answer the question adequately, one must avoid the conventional decomposition of the nominal yield into breakeven inflation and real yield. Both components do not express clean expectations. Being derived from traded securities, they also include a price for risk (risk premium) and trading (liquidity premium). The more uncertain the market environment, the less reliable they are as a proxy for expectations of the real equilibrium rate or long-term inflation. The current situation is a case in point. Let’s define the liquidity premium as the compensation investors demand for holding a less liquid bond than a normal fixed-rate US Treasury. Normally the premium is positive, but it can turn negative if there is overshooting demand. Instead of receiving the premium, investors then pay a premium to hold the desired bond. This is exactly what we are currently observing. Market conditions for inflation-protected US Treasuries (TIPS) have become very tight as investors have massively jumped on the reflation trade (i.e. record inflows for TIPS ETFs) while Fed purchases were still reducing available supply. If we adjust the real yield for the distorting liquidity effect by subtracting the liquidity premium, we see that it has already returned to the pre-crisis level. So the recovery is already priced in, the signal is just blurred.



Patrick Krizan
Allianz SE