Wednesday, June 3, 2009

Is the rise in US Treasury yields a problem? Part II

The last post concluded that for highly rated/government near instruments yields are rising whereas for lower rated instruments yields are still falling.
This post tries to analyse where the rise in UST yields comes from. The first chart shows 10y nominal yields, 10y real and 10y break-even yields as incorporated in inflation-linked Treasuries (TIIs). This years' rise in nominal yields was mostly down to a rise in break-even inflation rates from around 0%. Furthermore, real yields kept falling earlier this year (in line with falling equity markets) and fell significantly after the FOMC announcement to buy UST bonds. Only since then have real yields backed up somewhat, in line with rising risky assets/risk appetite and the increasing talk about green shoots as well as about the sustainability of the huge fiscal deficit. Still, real yields remain low by historical standards - in line with an easy monetary policy. Furthermore this historically low level of real yields does not yet seem to be a cause for concern in terms of holding back the real economy. Additionally, it does not yet hint at a significant rise in the real risk premia (on the back of the unsustainably large deficit/supply).
The second chart shows what I consider as one proxy of the liquidity premia incoroporated in US Treasuries. Following the collapse of Lehman Brothers, a huge liquidity premia was priced into US Treasuries, however only into nominal Treasuries and not any other assets, including TIIs. In turn, not only did swap spreads of US Treasuries balloon (as swaps underperformed vs. UST), but also TIIs underperformed heavily vs. USTs and by more than what the inflation outlook would have indicated, leading to a sharp collapse in break-even inflation rates. However, this led to a significant difference in what TIIs priced as break-even inflation and in what Inflation Linked Swaps priced for the same economic variable (see second chart).
After having reached a level of 150bp at the start of the year, the spread between TII break-evens and inflation-linked swaps has narrowed by almost 100bp. This means that TII break-evens rose 100bp more than inflation priced into inflation-linked swaps. In turn, I think that the associated 100bp rise in 10y UST (out of the total rise of 160bp since the start of the year), is purely down to the pricing out of the former liquidity premia. Pricing out this premia (and more so the underlying flows out of UST into risky assets) should be seen as a positive sign for the economy given that it suggests that the credit crunch is easing. The remaining 60bp of the rise in 10y UST yields can be split down into a "proper" rise of inflation expectations of around 90bp (as measured via the change in inflation-linked swaps) and a fall in real yields of around 30bp.
Therefore, at a maximum I would only consider 60bp of the rise in 10y UST as a cause for concern for the economy.

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