Inflation break-even and premium-adjusted maturity spreads

Expected inflation derived from Treasury-TIPS spread is tainted risk and liquidity premiums. The difference between expected future short rates and current short rates is also hidden by the risk premium. Here are the adjusted spreads:

Figure 1: The five-year inflationary break-even is calculated as the five-year Treasury yield minus the five-year TIPS yield (blue, left scale), the five-year break-even adjusted for the inflation risk premium and the DKW liquidity premium (red, left scale), both in %. Recession dates as determined by the NBER are in grey. Source: FRB via FRED, Treasury, NBER, KVV following D’amico, Kim and Wei (DKW) gained access to 8/4 and the author’s calculations.

The adjusted series assumes an upward trend in expected inflation due to the expansion of the Russian invasion of Ukraine, but less than that indicated by the simple Treasury-TIPS spread (and no downward trend recently).

How have recent publications affected inflation expectations? On fig. 2 shows the detail.

Figure 2: The five-year inflationary break-even is calculated as the five-year Treasury yield minus the five-year TIPS yield (blue, left scale), the five-year break-even adjusted for the inflation risk premium and the DKW liquidity premium (red, left scale), both in %. Source: FRB via FRED, Treasury, KVV following D’amico, Kim and Wei (DKW) gained access to 8/4 and the author’s calculations.

Inflationary breakeven rises with GDP growth and the release of the PCE deflator, but remains unchanged with today’s employment numbers (oddly enough). However, to the extent that the Treasury-TIPS spread incorrectly measures expectations, we should be somewhat cautious about this result (inflation expectations do decline with the release of adjusted GDP data).

What about the 10yr-3mo spread? In recent weeks, the unadjusted rate has fallen sharply, approaching an inversion.

Figure 3: 10-year and 3-month Treasury spreads (dark blue) and implied future nominal rates over the next ten years (pink), both in %. Recession dates as determined by the NBER are in grey. Source: FRB via FRED, Treasury, NBER, KVV following D’amico, Kim and Wei (DKW) gained access to 8/4 and the author’s calculations.

The gap between 10 years and 3 months turned negative in 2019 and again with the onset of the pandemic. The yield curve steepened sharply after the results of the snap elections in Georgia, and then, contrary to common sense, rose again with the expansion of the Russian invasion of Ukraine. The spread has fallen sharply since May 6th.

The spread includes an inflation risk premium, so the yield curve slopes upward on average. Therefore, the standard spread of 10 years-3 months is not necessarily equal to the difference between the 3-month return over the next 10 years and the current 3-month return. I show the sum of future three-month real returns and future three-month inflation rates over the next ten years as a pink line in Figure 2. This line probably better represents the heightened expectations for growth in the first and second quarters of 2021, as well as the fall. estimated growth prospects in May.

The details also suggest an expected reaction in asset prices to recent releases.

Figure 4: 10-year and 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’s calculations.