Great Graphic: Real Rates in US are Elevated

The US 10-year yield fell briefly below 1.32%
last July. 
The yield slowly rose to reach 1.80% in mid-October. 
The day after the election, the yield initially slipped to almost 1.71%.  This was a bit of a miscue, and the yield rose sharply to hit almost 2.64% the day
after the FOMC hiked rates for the second time in the cycle on December
14.   The yield backed off to hit 2.33% at the end of last
week. 

The difference between the conventional yield
and the inflation-linked yield (TIPS),
the 10-year breakeven, climbed with conventional yield until the middle of
November.
  Since the election, the increase in the conventional bond
yield has not been matched by the increase the breakeven. 

This is
depicted
in the Great Graphic
here, created on Bloomberg. The yellow
line is the conventional 10-year bond yield.
  The white line is the
10-year breakeven rate.  The gap between the two shows the real rate (nominal
minus inflation expectation).   What is remarkable is the sharp rise
in the real 10-year yields since the election.  

The nominal interest rate is usually thought of as having two
components:  the real rate and the premium. 
There are several
factors that could be part of the premium, but it often, and especially for US
Treasuries, is thought to be essentially inflation expectations.  In other
countries and other products (including TIPS) the premium may be more
complicated.  There may be a liquidity premium.  There may be a
political risk premium.  There may be a currency premium too, for
example.  

At the end of the week, the University of
Michigan will report the preliminary results of its survey of inflation
expectations.
  It asks questions
to determine the one-year inflation outlook and the 5-10 year outlook. 
The longer-term inflation expectations are the most relevant for policymakers.
In December, the FOMC statement said that “Market-based measures of
inflation compensation have moved up considerably but still are low; most
survey-based measures of longer-term expectations are little changed, on balance in recent months.” 

When the FOMC met, it had access to the preliminary December results.  It
showed a slight decline to 2.5% from 2.6%. 
However, before Christmas, the final report showed a decline to 2.3%.  This is the lowest on record (time series goes
back to 1979). 

The rise in US
yields since the election is not so much an increase inflation expectations but
real yields.
An increase in real yields could be a reflection of an increase in the demand for
capital (which could come from the private and/or public sector).  It could
reflect anticipated changes to supply-side factors (tax cuts and regulation)
that boost profitability.  

Investors in fixed income products typically
get the nominal returns.
  Our bullish view of the dollar was predicated on widening nominal interest
rate differentials.   We think that for portfolio investment decision,
nominal rates are key.  However, for understanding the economic impact of
interest rates, economists may be best served by looking at real rather than
nominal rates.  That said, a country with high real rates and a slowing
economy could spur a sharp decline in nominal yields. (bond market rally).    



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