Breakeven of inflation and forward spreads adjusted for Premia

Expected inflation deducted from the Treasury-TIPS spread is tainted by risk and liquidity premia. The expected difference between future short-term rates and current short-term rates is also obscured by risk premiums. Here are the correct spreads:

Figure 1: Five-year inflation breakeven calculated as five-year Treasury yield minus five-year TIPS yield (blue scale, left), five-year breakeven adjusted by inflation risk premium and liquidity premium for DKW (red scale , left), both in%. NBER has defined recession dates shaded in gray. Source: FRB via FRED, Treasury, NBER, KWW after D’amico, Kim and Wei (DKW) accessed 8/4 and author calculations.

The adjusted series suggests an upward movement in expected inflation with Russia’s extensive invasion of Ukraine, but less than that indicated by the simple Treasury-TIPS spread (and no downward movement recently).

How have recent releases affected inflation expectations? Figure 2 presents a detail.

Figure 2: Five-year inflation breakeven calculated as five-year Treasury yield minus five-year TIPS yield (blue scale, left), five-year breakeven adjusted by inflation risk premium and liquidity premium for DKW (red scale , left), both in%. Source: FRB via FRED, Treasury, KWW after D’amico, Kim and Wei (DKW) accessed 8/4 and author calculations.

The breakeven inflation increases with the advance of GDP and the release of the PCE deflator, but remains constant with today’s employment numbers (oddly). However, to the extent that the Treasury-TIPS spread measures expectations, we should be a little wary of this outcome (inflation expectations decrease as GDP is released with the adjusted measure).

What about the 10-year-3-month spread? The unadjusted has made a big splash in recent weeks, approaching reversal.

Figure 3: 10-year-3-month Treasury spreads (dark blue) and implied future nominal rates over the next ten years (pink), both in%. NBER has defined recession dates shaded in gray. Source: FRB via FRED, Treasury, NBER, KWW after D’amico, Kim and Wei (DKW) accessed 8/4 and author calculations.

The gap between 10 years and 3 months turned negative in 2019 and again with the onset of the pandemic. The yield curve steeply tilted with the results of the special elections in Georgia, and then counterintuitively recovered with the extensive Russian foray into Ukraine. The spread dropped dramatically from May 6th onwards.

The spread incorporates an inflation risk premium such that, on average, the yield curve tilts upwards. Thus, the standard 10-year-3-month spread is not necessarily equal to the difference between yields at 3 months over the next 10 years compared to the current 3-month yield. I show the sum of 3-month future real returns and 3-month future inflation rates over the next ten years as the pink line in Figure 2. This line probably best illustrates the higher growth expectations in 2021Q1-Q2, as well as the decline in the outlook. of perceived growth in May.

The detail also suggests expected asset price responses to recent releases.

Figure 4: 10-year-3-month Treasury spreads (dark blue) and implied future nominal rates over the next ten years (pink), both in%. Source: FRB via FRED, Treasury, KWW after D’amico, Kim and Wei (DKW) accessed 8/4 and author calculations.