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Understanding the rise in US long-term interest rates

Summary:
Tobias Adrian, Rohit Goel, Sheheryar Malik and Fabio Natalucci in this IMF blog explain the reasons for rising US interest rates: The yield on a 10-year US Treasury reflects different elements. The real Treasury yield, which is a proxy for expected economic growth, as well as the inflation breakeven rate, a measure of investors’ future inflation expectations. Real yield plus breakeven inflation gives us the nominal rate. Importantly, breakeven rates and real yields represent not only current market expectations of inflation and growth. They also include the compensation investors require for bearing the risks associated with both elements. The inflation risk premium is related to future inflation uncertainty. And the real yield includes a real risk premium component, which reflects

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Tobias Adrian, Rohit Goel, Sheheryar Malik and Fabio Natalucci in this IMF blog explain the reasons for rising US interest rates:

The yield on a 10-year US Treasury reflects different elements. The real Treasury yield, which is a proxy for expected economic growth, as well as the inflation breakeven rate, a measure of investors’ future inflation expectations. Real yield plus breakeven inflation gives us the nominal rate.

Importantly, breakeven rates and real yields represent not only current market expectations of inflation and growth. They also include the compensation investors require for bearing the risks associated with both elements. The inflation risk premium is related to future inflation uncertainty. And the real yield includes a real risk premium component, which reflects the uncertainty about the future path of interest rates and economic outlook. The sum of the two, commonly referred to as the term premium, represents the compensation required by investors to bear interest-rate risk embedded in Treasury securities.

In addition, the 10-year yield can be usefully split into two different time horizons, as different factors may be at work over the short- versus longer-term: the 5-year yield, and what markets call the “5-year-5-year forward,” covering the second half of the bond’s 10-year maturity.

The recent increase in the 5-year yield has been driven by a steep rise in short-term breakeven inflation. This has gone hand in hand with a rise in commodity prices, as the global economic recovery has gained traction, as well as with the Federal Reserve’s reiterated intention to maintain an accommodative monetary policy stance to achieve its objectives of full employment and price stability.

By contrast, the increase in the 5-year-5-year forward is primarily due to a sharp rise in real yields, pointing to an improvement in growth outlook with longer-term breakeven inflation appearing well-anchored.

Putting all this together, the rise in the 5-year inflation breakeven reflects an increase in both expected inflation and inflation risk premia. Meanwhile, the sharp rise in the longer-term real yield is primarily due to a higher real risk premium. This points to greater uncertainty about the economic and fiscal outlook, as well as the outlook for asset purchases by the central bank, in addition to longer-term drivers such as demographics and productivity.

What does this mean for Fed?

Should the US central bank control or at least attempt to shape these dynamics? Monetary policy remains highly accommodative, with sharply negative real yields expected in coming years. An overnight policy rate essentially at zero, in combination with the Federal Reserve’s indication that it will allow inflation to moderately overshoot its inflation target for some time, provides significant monetary stimulus to the economy, as investors do not anticipate an increase in the policy rate for at least a couple of years. Careful and well-telegraphed communication about the expected future path of short-term interest rates has shaped the yield curve at the shorter end.

However, the longer end of the yield curve is also importantly affected by asset purchases. In fact, asset purchases as the main unconventional monetary policy tool in the United States operate via a compression of risk premia, supporting risky asset prices and easing broader financial conditions. Hence the rise of real risk premia at the 5-year-5-year forward horizon can be interpreted as a reassessment of the outlook for, and risks surrounding, asset purchases, taking into account the expected increase in Treasury supply related to fiscal support in the United States.

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A gradual increase in longer-term US rates—a reflection of the expected strong US recovery—is heathy and should be welcomed. It would also help contain unintended consequences of the unprecedented policy support required by the pandemic, such as stretched asset prices and rising financial vulnerabilities.

Amol Agrawal
I am currently pursuing my PhD in economics. I have work-ex of nearly 10 years with most of those years spent figuring economic research in Mumbai’s financial sector.

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