Break-even point for inflation and interest-adjusted spreads

The expected inflation inferred from the Treasury-TIPS spread is tinged with risk and liquidity premiums. The difference between the expected short rates in the future and the current short rates is masked by the risk premium. Here are the modified margins:

Figure 1: The five-year inflation equation calculated based on the five-year Treasury yield minus the five-year TIPS yield (blue, left scale), the five-year parity adjusted for inflation risk premium and the liquidity premium per DKW (red, left scale), both in %. Selected NBER slack dates are shaded in grey. Source: FRB via FRED, Treasury, NBER, KWW After D’amico, Kim and Wei (DKW) accessed 8/4, author accounts.

The adjusted series indicates an upward movement in expected inflation with the expanded Russian invasion of Ukraine, but less than that indicated by a simple Treasury-TIPS spread (and no downward movement recently).

How have recent releases affected inflation expectations? Figure 2 provides details.

Figure 2: The five-year inflation equation calculated based on the five-year Treasury yield minus the five-year TIPS yield (blue, left scale), the five-year parity adjusted for inflation risk premium and the liquidity premium per DKW (red, left scale), both in %. Source: FRB via FRED, Treasury, KWW Post D’amico, Accessed Kim and Wei (DKW) 8/4, author accounts.

The inflation breakeven rises with the advance of GDP and PCE deflator releases, but it remains flat with today’s (odd) employment numbers. However, to the extent that the Treasury-TIPS spread misses expectations, we should be somewhat wary of this outcome (inflation expectations fall with the release of GDP with the adjusted measurement).

How about a 10yr-3mo spread? The unadjusted has gone through a major decline in recent weeks, and is close to inverting.

Figure 3: 10 years – 3 months Treasury spread (dark blue), and implied future nominal rates over the next 10 years (pink), both in percentage. Selected NBER slack dates are shaded in grey. Source: FRB via FRED, Treasury, NBER, KWW After D’amico, Kim and Wei (DKW) accessed 8/4, author accounts.

The gap between 10 years and 3 months turned negative in 2019, and again with the onset of the pandemic. The yield curve sloped sharply with the election results for Georgia, and then rose again with Russia’s expanded incursion into Ukraine. The spread fell sharply from May 6 onwards.

The spread includes an inflation risk premium so that the yield curve slopes on average. Hence, the standard 10 year – 3 month spread does not necessarily equal the difference between the 3 month returns over the next 10 years versus the current 3 month return. I present the sum of future 3-month real returns and 3-month future inflation rates over the next 10 years as the pink line in Figure 2. Perhaps this line better shows the rising expectations of growth in the first quarter of 2021 to the second quarter, as well as the decline in projected growth prospects in May.

Details indicate expected asset price responses to recent releases as well.

Figure 4: 10 years – 3 months Treasury spread (dark blue), and implied future nominal rates over the next 10 years (pink), both in percentage. Source: FRB via FRED, Treasury, KWW Post D’amico, Accessed Kim and Wei (DKW) 8/4, author accounts.

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