Expectations and Expectation Uncertainty: some thoughts on US long-term yields
- Market expectations of increased monetary policy tightening by the Fed have built up continuously.
- Inflation expectations have increased lately but remain anchored at the Federal Reserve’s inflation target of 2 %.
- The term premium’s U-turn is associated with a rather sudden acceleration of 10Y US Treasuries.
- The inflation risk premium sets sail to reach positive territory.
During the first eight weeks of 2018, we have seen marked increases in government bond yields. US Treasuries at maturities of 10 years have gained almost 50 basis points (bp) trading close to 2.9 %. Comparable German Bunds have increased by around 30 bp reaching 0.7 %. The pick-up in yields has received widespread public attention being associated with increased volatility at global stock markets. In a nutshell, the general-held view goes as follows: Higher than expected wage growth in the US has led market participants to revise their view on inflation as well as the pace of monetary policy normalization. If the Federal Reserve increases interest rates faster to keep the economy in check, the general yield level increases, which reduces the relative attractiveness of holding stocks. In this week’s analysis, we take a closer look at the drivers of long-term yields. We have already investigated the link between wages and inflation in a previous UCM Weekly.
For the current movement in yields, inflation expectations seem to be the appropriate starting point. Figure 1 (see pdf) shows four different measures of inflation expectations for the US economy. Firstly, two survey-based measures based on a consumer survey conducted by the University of Michigan and a survey among professional forecasters conducted by the Federal Reserve Bank of Philadelphia. Secondly, a market-based inflation expectation measure, so called breakeven inflation rates, which is calculated based on the difference between nominal government bond yields and yields on inflation-linked bonds (TIPS). And thirdly, a model-based inflation expectation measure from the Federal Reserve Bank of Cleveland. The consumer survey measure shows a longer-term trend decline, while the survey among professional forecasters is much more stable around 2.2 % (average since 2013). Model-based inflation expectations started to pick up in mid-2017, while breakeven inflation rates started to increase later in the year, however, at a faster pace. Both measures have reached levels just above 2 % in February 2018. The survey of professional forecasters increased slightly to 2.25 % in February, a value which has already been reached in December 2017. It would, therefore, be too early to interpret the recent rise in inflation expectations as a de-anchoring of the Fed’s 2 % inflation target. Even in the event of a further increase in breakeven inflation rates it should be kept in mind that breakeven inflation rates include an inflation risk premium. Moreover, recent research has confirmed that yield-implied long-term inflation expectations are quite constant, after adjusting for inflation risk and liquidity risk premia, and move close to those of Professional Forecasters.
Hence, inflation expectations have increased lately but, until now, remain anchored at the Fed’s inflation target. It should be kept in mind, however, that inflation expectations take future monetary policy decisions already into account. In order to learn more about the recent movement in yields, we need to know the market’s view on future monetary policy trajectories. By applying, so called term structure models, government bond yields can be decomposed into an average of future expected short-term interest rates, the risk-neutral rate, and a term premium. Term premium estimates provided by researchers at the Federal Reserve Bank of New York allow us to decompose the change in 10Y US Treasury yields. Figure 2 (see pdf) shows to what extent the change in the yields, since the end of 2016, can be explained by the risk-neutral rate and the term premium. Interestingly, it shows that the risk-neutral rate started to increase well before the yield on 10Y US Treasuries. The increase, however, was compensated by a further decrease in the term premium. It was only in 2018, once the term premium picked-up again, that the yield increased. Hence, the development of the term premium was responsible for making a continuous build-up of expectations on future short-term interest rates look like a rather sharp market reaction.
The term premium seems to be important, however, what exactly does it measure? The term premium can be interpreted as the additional yield an investor receives for holding long-term rather than short-term bonds. It has been well established that the term premium has fallen since the 1990s and even turned negative in recent years. Figure 3 (see pdf) shows this development by using two different measures of the 10Y term premium, which historically vary quite a bit but show almost identical values since 2016. It also shows that the recent pick-up of the term premium from around -0.5 % to -0.25 % is relatively small within a quite volatile time-series.
Nevertheless, it is worth asking why the term premium has increased? We argue that the inflation risk premium has a role to play. Let’s take a step back and look at inflation expectations again. The market-based measure of inflation expectations, or breakeven inflation rates, are subject to inflation risk and liquidity premia. These premia are also components of the term premium estimates presented in figure 2 and 3. One way to quantify those is to take the difference between survey based inflation expectation measures and the breakeven inflation rates. Doing so, by using the survey of professional forecasters as an unbiased benchmark, results in an inflation risk premium measure which has recently set sail to reach positive territory – figure 4 (see pdf). Until recently, the real term premium, which is the difference between the term premium and the inflation risk premium, has been the main driver. For the last two years, however, also the inflation risk premium has played a decisive role, especially for moving the term premium into negative territory. An increase in the inflation risk premium would suggest increased uncertainty regarding inflation expectations. However, a negative inflation risk premium has also been associated with risks of deflation. The current environment with US wages and inflation surprising to the upside but still not enough evidence to indicate a trend increase, would suggest rising uncertainty about inflation expectations. The minuets of the latest Federal Open Market Committee (FOMC) meeting also share the view of a gradual rise in inflation: “Participants anticipated that inflation would continue to gradually rise as resource utilization tightened further and as wage pressure became more apparent.” As we have argued previously, the Phillips Curve is well and active but subject to a time lag and the inflationary effect of tightening labor markets has weakened over time.
To sum up, we argue that sustained underlying economic moment with additional positive stimuli to be expected from the tax reform has confirmed the gradual monetary policy tightening by the Fed, which is reflected in higher expectations of future short term interest rates. Additionally, long-term inflation expectations remain anchored at the Fed’s 2 % inflation target, reaffirming the central bank’s credibility. Nevertheless, a rise in the inflation risk premium suggests uncertainty around market participants’ inflation expectations to have increased lately. An additional factor, which has not been addressed here, is the possible effect of rising US fiscal deficits on the term premium.
Martin Ertl Franz Zobl
Chief Economist Economist
UNIQA Capital Markets GmbH UNIQA Capital Markets GmbH
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