A Significant Divergence Between The Components Of 10 Year

by Steven Vannelli, Knowledge Leaders Capital Blog

Employing basic bond math, we can decompose the US Treasury bond into two pieces: real rates and break-even inflation expectations. Because real rates (TIPS) and nominal rates (US Treasuries) are directly observable, break-even inflation is relatively easy to determine.

Taking this logic one step further, we can actually decompose a US Treasury bond into three components: 1) growth expectations, 2) a term premium and 3) break-even inflation expectations. A term premium is the extra yield an investor demands for holding longer dated securities, often insurance against an unexpected spike in inflation.

The term premium cannot be directly observed; it has to be calculated using a model. The Adrian, Crump and Moench (ACM) term premium is the one most used by the Federal Reserve.

So, in the end we have the following identities:

Nominal Rates = Real Rates + Breakeven Inflation

Real Rates = ACM Term Premium + Growth Expectations

Nominal Rates = ACM Term Premium + Growth Expectations + Breakeven Inflation

When we decompose the YTD move in the 10-Year US Treasury, we can see a significant divergence between the components. The term premium and breakeven inflation have fallen while growth expectations have increased. This goldilocks scenario has certainly helped stocks move higher this year.

Historically the nominal 10 Year US Treasury is tightly linked to term premiums, so it is not surprising to see the two move mostly in tandem this year.

The term premium is generally negatively correlated with growth expectations, so it is logical to see growth expectations having moved higher while term premiums fell.

Since the term premium is generally tightly linked to inflation expectations, it makes sense to see breakeven inflation expectations have moved lower alongside the term premium YTD.

The best macroeconomic driver we can identify that brings these components into a coherent focus is the move down in the US Dollar YTD.

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Author: Travis Esquivel

Travis Esquivel is an engineer, passionate soccer player and full-time dad. He enjoys writing about innovation and technology from time to time.

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