Why have far-forward nominal Treasury rates increased so much in the past few years? Old risks reemerge in an era of Fed credibility

What it says

The authors break the 9-to-10-year forward Treasury rate into four parts: expected inflation, an inflation risk premium, the expected real short rate and a real risk premium. Inflation compensation from TIPS and survey measures of long-run inflation have held near 2 percent, so the first two have not risen, and estimates of the neutral real rate have moved only a little. By elimination, the increase has come from the real risk premium, which they estimate has risen by about 200 basis points. They offer two explanations. Investors now see a larger chance of damaging supply shocks, which raise inflation and weaken activity at once, after the pandemic period revived that risk. And projections of federal debt have climbed, raising the possibility that yields must rise if debt comes to look unsustainable. Stable inflation compensation suggests markets still trust the Fed to contain inflation.

What to take from it

1. 1

   The rise in the 9-to-10-year forward rate over five years is the largest since the late 1970s and early 1980s.

2. 2

   Changes in that forward rate explain more than 80 percent of the variation in annual changes in the 10-year yield over 50 years.

3. 3

   The 10-year has stayed somewhat above 4 percent despite 175 basis points of cuts to the federal funds target.

4. 4

   The total far-forward risk premium sits around its 85th percentile since 1971, yet remains about 200 basis points below its early-1980s peaks.

5. 5

   Congressional Budget Office projections put debt near 120 percent of GDP in about ten years, above the Second World War record.

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