Talking Data: U.S. Treasury Real Yields Refuse to Budge

In today’s installment, Jim and Ben discuss extremely low real yields and some of the oddities occurring within inflation expectations.

    • What is steering extremely low real yields? Federal Reserve? Economic growth?
    • Will rising nominal yields bite if real yields do not follow along?
    • Is demand for inflation-friendly asset and protection overdone?

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The Federal Reserve is very much at the helm of real yields. Sentiment and uncertainty as measured via NLP of official communications explains over 68% of the variation in 10-year real yields. Sentiment and uncertainty have plummeted to record lows. Therefore, Powell et al are communicating very dovish language with the least amount of ambiguity. Investors are taking them at the word by driving down real yields.

Bottom line, rising yields do not become concerning until real yields begin to budge higher.

The Federal Reserve’s certainty in dovish policy has allowed U.S. Treasury implied volatility to plummet since March 2020. Swaption volatilities are beginning to rebound, but have yet to flash any warning signs.

The Federal Reserve’s commitment to staying easy has allowed so-called zombie companies to outperform their living brethren. We identified 668 companies (>$300 million in market cap) with three-year average EBIT-to-interest expense ratios below one. Therefore, 16.3% of U.S. companies qualify as zombies.

Falling real yields at the very least coincide with rising zombie counts. 

Real yields have thus far refused to chase nominal yields higher thanks to the Federal Reserves new AIT framework. The committee has communicated an inflation overshoot toward 2.5% year-over-year before considering a rate hike. 

Investors’ inflation outlook has risen the floor for headline CPI from 1.5% to 2.0% year-over-year. Inflation swap caps and floors reveal a 73% probability headline CPI can average above this floor for the next 10 years. 

However real excitement will not take place until inflation expectations reach the 2.5% year-over-year milestone. Inflation swap cap and floors show probabilities ranging from 27% to 34% headline CPI can exceed 2.5% year-over-year for the next 2 through 30 years. We need to see 50+% probabilities to believe risk assets will view yields and inflation as hindrances.

Lastly, the TIPS breakeven curve offers a great measure of the Federal Reserve’s AIT framework. The spread between U.S. 2 and 10-year TIPS breakevens has inverted by its greatest since 2008. Inversions have always led to a steeper TIPS breakeven curves by way of tumbling short-end inflation expectations. If this time is different, then the TIPS breakeven curve would need to remain inverted by a degree and length of time not seen in history. 

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