## INTRODUCTION (gsnea2021003) ## Source details **Canonical URL:** [INTRODUCTION (gsnea2021003)](https://www.imf.org/-/media/files/publications/gfs-notes/2021/english/gsnea2021003.pdf) ## Other formats - [Markdown version](/-/media/files/publications/gfs-notes/2021/english/gsnea2021003.pdf.md) - [Structured JSON version](/-/media/files/publications/gfs-notes/2021/english/gsnea2021003.pdf.json) --- ### Overview - Advanced economy bond yields rose sharply since the beginning of 2021, with a particular investor focus on the United States. - The nominal 10-year US Treasury yield increased almost 80 basis points at its peak in 2021. - The rise in US yields reflects, in part, marked improvements in the economic outlook as recovery from the coronavirus disease (COVID-19) pandemic accelerates. - The increase in yields has passed through to the pricing of other advanced economy and emerging market bond yields and could have significant spillovers to the global financial system. - The charts are refreshed as of the end of May 2021. ### Decomposition of advanced economy nominal yields - Nominal yields are decomposed into: - (i) the real yield and - (ii) breakeven inflation. - Breakeven inflation is the difference between nominal and real yields and is viewed as a market-implied measure of inflation expectations; the real yield reflects growth expectations. - An increase in real yields could signal an improvement in the economic outlook via: - an increase in return on investment that raises investment demand; and - higher expected growth boosting future earnings, inducing households to increase current consumption and save less—leading to higher real yields. - Relationship expressed as: - nominal yield = real yield + inflation breakeven ............................(1) ### Yield-curve information and horizons - Yield-curve information embeds market expectations about yields at different horizons/tenors. - The 5-year nominal yield gauges developments corresponding to real yield and inflation breakeven over the next 5 years (near-term). - The 5-year–5-year forward yield (5yr5yr) conveys information about a longer-term horizon spanning years 6 to 10. - The 5yr5yr forward yield can be inferred from 5-year and 10-year nominal yields as: - 5yr5yr forward yield = { (1+10yr yield)10 × (1+5yr yield)−5 }1/5 ............................. (2) - Analysis focuses on decomposing the 5yr and 5yr5yr nominal yields to extract market-implied expectations for near- and longer-term horizons. ### Key results for the United States - The 10-year inflation breakeven rose to 2.7 percent, its highest level since early 2013; this increase appears to be a major driver of the rise in the US nominal yield since March. - The 10-year real yield displayed a relatively sharp increase only since March 2021. ### Key observations on nominal and real yields - The 10-year real yield displayed a relatively sharp increase only since March 2021. - The 5-year nominal yield increase was driven primarily by an increase in inflation breakeven; the 5-year real yield remained relatively unchanged. - The 5-year inflation breakeven reached 2.6 percent, its highest level since 2008. - For the 5yr5yr tenor, the increase in the real yield appears to have been the primary driver of the nominal yield increase, with inflation breakevens displaying relatively little variability. - Across tenors: - real yields have an upward sloping term structure; and - inflation breakevens display a downward sloping term structure. ### Results for other major advanced economies - 10-year nominal yields rose by: - Euro Area 40 basis points, - United Kingdom 60 basis points, and - Japan about 10 basis points, taking cues from the 70 basis point rise in the US nominal yield. - Heterogeneity across tenors and jurisdictions in drivers of nominal yields: - United Kingdom, like the United States, has seen an increase in the 10-year real yield. - Euro Area and Japan saw relatively subdued changes in real yields for the 10-year tenor. - Real yields rose across the board for the 5yr5yr tenor, especially in the United States and the United Kingdom, with increases meaningfully larger than movements for the 5-year tenor. - Inflation breakevens increased across jurisdictions, particularly for the 5-year tenor compared with the 5yr5yr tenor. ### Decomposition of US inflation breakevens - Breakeven inflation = expected inflation + inflation risk premium (IRP) as per equation (3) in the source. - Methodology: - Joint affine term structure model of nominal and real bond yields (based on Abrahams et al. (2016)). - Zero coupon bond yields from Gurkaynak et al. (2007, 2010); Nelson–Siegel–Svensson curve parameters from the Board of Governors of the Federal Reserve to back out zero-coupon yields up to 10 years. - TIPS payouts computed using seasonally unadjusted CPI-U from the Bureau of Labor Statistics. - Adjustment for potential TIPS illiquidity using: ratio of primary dealer nominal Treasury transaction volumes to TIPS volumes; bid-ask spreads of TIPS relative to nominals; TIPS yield fitting error from the Nelson–Siegel–Svensson model. - Key results: - Expected inflation over the next five years has recovered significantly from the March 2020 trough and is currently hovering within the 2.0–2.5 percent range, slightly above the average level prevailing over 2018–2019. - Expected inflation over the 5yr5yr segment has recovered somewhat but is currently just below pre-pandemic levels; recovery is more sluggish compared with the 5-year horizon. - The near-term (5-year) expected inflation is slightly above the longer-term (5yr5yr) horizon. - TIPS are CPI-indexed; near-term moves in expected inflation and breakevens partly reflect the recent sharp spike in oil prices, but adjusting for oil price impact does not meaningfully alter trajectories since March 2020. - The IRP for both 5-year and 5yr5yr breakeven decompositions has turned positive and is currently at a multi-year high. - From end-March 2020 to end-March 2021: - About 45 percent of the increase in liquidity-adjusted 5-year breakeven is due to an increase in the IRP for that tenor; the remaining 55 percent is due to an increase in the expected inflation component. - For the 5yr5yr, close to 10 percent of the increase is an increase in expected inflation and 90 percent is attributable to an increase in risk premiums. - Comparing trough-to-peak periods: - June 2016–June 2017: relative contributions of IRP and expected inflation to the increase in breakeven were similar at the 5yr5yr horizon; for the 5-year the bulk was due to change in expectations with about 15 percent attributable to increased IRP. - October 2008–October 2009: rise in expected inflation was a significant contributor to increased breakeven at both near- and longer-term horizons. - ETF evidence: - Flows into inflation-protected bond ETFs have averaged 5 percent of assets under management over the last three months, compared with 1.5 percent over the last five years. ### Decomposition of US real yields - Real yield = risk-adjusted real yield + real-term premium as per equation (4) in the source. - Methodology: decomposition delivered via estimation of the joint nominal and real term structure model noted above. - Key results: - The 5-year real yield has remained low, even on a risk-adjusted basis, with a slight uptick in the real-term premium in recent months. - Compression of real yield at the 5-year horizon reflects intended near-term effects of ultra-accommodative monetary policy, given higher near-term inflation expectations and policy rates near the zero-lower bound. - The 5yr5yr real yield increase has been more pronounced: - The risk-adjusted component for this tenor has increased somewhat. - The bulk of the increase is due to a rise in the real-term premium over the longer term. - The rise in 5yr5yr real yield largely reflects increased uncertainties around growth and the path of policy over the longer term, and may reflect concerns around large fiscal deficits and issuance needs and longer-term structural factors such as productivity and demographics. ### Inflation expectations from consensus surveys - Consensus Economics forecasts used to analyze very near term (1 year) and medium term (5 years) inflation expectations. - Findings: - Very near-term inflation expectations increased sharply since June 2020, ranging between 30–45 basis points across the major advanced economies. - Medium-term (5-year) changes have been relatively benign. - Latest consensus expectations indicate inflation is expected to remain broadly within the target range over the medium term. - Country ordering in latest near-term forecasts: United Kingdom highest, followed by United States, Euro Area, and Japan. ### Signals from inflation options - Inflation options (caps and floors) infer probability distributions around future inflation expectations using a methodology based on Black’s model as in Feldman et al. (2015). - Findings: - Inflation expectations increased steadily in the United States, with the probability distribution moving significantly to the right. - Market-implied probabilities of high inflation (>2 percent) increased sharply in both the United States and Euro Area; probability of low inflation (<1 percent) declined materially. - Structural differences: - Probability of high inflation in the United States is at almost 70 percent compared to 10 percent in the Euro Area. - Probability of low inflation in the Euro Area is still relatively high at 30 percent, while in the United States it is almost negligible. - Over the longer horizon, the probability of low inflation (<1 percent) in the United States is at historical lows and has corrected sharply from the peak of the COVID-19 sell-off. - The probability of low inflation has declined in the Euro Area but remains higher than 2018 troughs, indicating notable downside risks. ### CONCLUSION AND POLICY IMPLICATIONS ### Decomposition of rise in nominal bond yields - The analysis decomposes the sharp rise in the United States and other major advanced economy nominal bond yields into inflation expectations and real yields. ### Findings on inflation expectations - US inflation expectations appear to be well-anchored over the longer term. - There is evidence of a transitory increase expected over the near-term horizon in the United States. - For the Euro Area, the United Kingdom, and Japan, inflation expectations appear to be displaying a meaningful increase over both the near- and longer-term horizons. - Near-term expectations have risen somewhat more prominently in these economies, potentially reflecting “base effects” in inflation measurement, as the recovery gains traction with re-opening of these economies. - The difference in near- versus longer-term dynamics of US inflation expectations can be considered in line with the Federal Reserve’s new objective of allowing inflation to moderately overshoot its target for some time. ### Findings on real yields and monetary policy stance - Taken together with significant monetary stimulus with the overnight policy rate essentially held at zero, the finding of negative expected real yields over the horizon of next few years suggests investors expect US monetary policy conditions to remain highly accommodative over the near term. - The short end of the yield curve appears well-anchored due to the Federal Reserve’s forward guidance on the path of rates and conditions that need to be met before considering a liftoff. - The longer end of the curve is also meaningfully affected by the Federal Reserve’s asset purchases program. - Asset purchases operate via the compression of risk premiums, supporting risky asset prices and easing broader financial conditions. - Evidence of a rise in real risk premiums over the longer term—at the 5yr5yr forward horizon—can be interpreted as a potential reassessment of the outlook for, and the risks surrounding, asset purchases, taking into account the expected increase in Treasury supply related to fiscal support in the United States. ### Policy challenges and recommendations for the Federal Reserve - There is a wide range of views among market participants regarding the outlook for asset purchases, as well as uncertainty about the parameters of the Federal Reserve’s new Average Inflation Targeting Framework. - An important challenge for the Federal Reserve, once the beginning of the policy normalization process draws closer, will be to provide clear and well-telegraphed communication about the pace of future asset purchases—and the reaction function more generally—to avoid unnecessary volatility in financial markets. ### Risks, welcome developments, and IMF baseline - A gradual increase in longer-term US rates—a reflection of the expected strong US recovery—is healthy and should be welcomed. - A gradual increase would also help contain unintended consequences of the unprecedented policy support required by the pandemic, such as stretched asset prices and rising financial vulnerabilities. - The IMF’s baseline expectation is one of continued accommodative financial conditions, even if US rates were to rise further. - However, an abrupt tightening of global financial conditions remains a risk. - Given the asynchronous and multispeed nature of the global recovery, fast and sudden increases in US rates could lead to significant spillovers around the world, tightening financial conditions in emerging markets and disrupting their recovery process. *IMF | Monetary and Capital Markets — gsnea2021003* ### INTRODUCTION ### INTRODUCTION ### Overview - Advanced economy bond yields rose sharply since the beginning of 2021, with a particular investor focus on the United States. - The nominal 10-year US Treasury yield increased almost 80 basis points at its peak in 2021. - The rise in US yields reflects, in part, marked improvements in the economic outlook as recovery from the coronavirus disease (COVID-19) pandemic accelerates. - The increase in yields has passed through to the pricing of other advanced economy and emerging market bond yields and could have significant spillovers to the global financial system. - The charts are refreshed as of the end of May 2021. - The authors thank Xingmi Zhang for excellent research assistance. The note has also benefitted significantly from the comments from Nassira Abbas, Tobias Adrian, Fabio M Natalucci, and Mahvash Qureshi along with comments from internal reviewers and participants at an internal seminar. ### Decomposition of advanced economy nominal yields - By standard economic theory, nominal yields may be decomposed into two general components: - (i) the real yield and - (ii) breakeven inflation. - Breakeven inflation—expressed as the difference between nominal and real yields—is commonly viewed as a market-implied measure of inflation expectations, while the real yield reflects growth expectations. - An increase in real yields could signal an improvement in the economic outlook via two potential channels: - It reflects an increase in return on investment, leading to an increase in investment demand. - Higher expected growth boosts future earnings, which, in turn, leads forward-looking households to increase current consumption and save less. The combination of lower savings and higher investment would translate into higher real yields. - The relationship is expressed as: - 푛표푚푖푛푎푙 푦푖푒푙푑 = 푟푒푎푙 푦푖푒푙푑 + 푖푛푓푙푎푡푖표푛 푏푟푒푎푘푒푣푒푛 ............................(1) ### Yield-curve information and horizons - Utilizing information contained within the yield curve is especially useful, given it embeds market expectations about yields at different horizons/tenors. - Developments corresponding to real yield and inflation breakeven over the next 5 years (relatively near-term) may be gauged by examining the 5-year nominal yield. - The 5-year–5-year forward yield conveys information about a relatively longer-term horizon; specifically, a period spanning years 6 to 10. - The 5yr5yr forward yield (henceforth labeled 5yr5yr) can be inferred from readily available 5-year and 10-year nominal yields as: - 5푦푟5푦푟 푓표푟푤푎푟푑 푦푖푒푙푑 = { (1+10푦푟 푦푖푒푙푑)10 × (1+5푦푟 푦푖푒푙푑)−5 }1/5 ............................. (2) - The analysis focuses on extracting market-implied expectations pertaining to the near- and longer-term horizons by decomposing the 5yr and 5yr5yr nominal yields, respectively. ### Key results for the United States - Having risen significantly in 2021, the 10-year inflation breakeven at 2.7 percent touched its highest level since early 2013. - This increase appears to be a major driver of the rise in the US nominal yield since March. *IMF | Monetary and Capital Markets — INTRODUCTION (gsnea2021003)* ### 2020. The 10-year real yield, however, displayed a relatively sharp increase only since March 2021 (Figure 1, ### gsnea2021003 - 2020. The 10-year real yield, however, displayed a relatively sharp increase only since March 2021 (Figure 1, ### Key observations on nominal and real yields - The 10-year real yield displayed a relatively sharp increase only since March 2021. - The 5-year nominal yield increase was driven primarily by an increase in inflation breakeven, while the corresponding 5-year real yield remained relatively unchanged. - The 5-year inflation breakeven reached 2.6 percent, its highest level since 2008. - For the 5y5yr tenor, the increase in the real yield appears to have been the primary driver of the nominal yield increase, with inflation breakevens displaying relatively little variability. - Across tenors, real yields have an upward sloping term structure, while inflation breakevens display a downward sloping term structure. ### Results for other major advanced economies - 10-year nominal yields rose by: Euro Area 40 basis points, United Kingdom 60 basis points, and Japan about 10 basis points, taking cues from the 70 basis point rise in the US nominal yield. - Heterogeneity exists across tenors and jurisdictions in drivers of nominal yields: - United Kingdom, like the United States, has seen an increase in the 10-year real yield. - Euro Area and Japan saw relatively subdued changes in real yields for the 10-year tenor. - Real yields rose across the board for the 5yr5yr tenor, especially in the United States and the United Kingdom, with increases meaningfully larger than movements for the 5-year tenor. - Inflation breakevens increased across jurisdictions, particularly for the 5-year tenor compared with the 5yr5yr tenor. ### Decomposition of US inflation breakevens - Breakeven inflation = expected inflation + inflation risk premium (IRP) as per equation (3) in the source. - Methodology: - Joint affine term structure model of nominal and real bond yields (based on Abrahams et al. (2016)). - Zero coupon bond yields from Gurkaynak et al. (2007, 2010); Nelson–Siegel–Svensson curve parameters from the Board of Governors of the Federal Reserve to back out zero-coupon yields up to 10 years. - TIPS payouts computed using seasonally unadjusted CPI-U from the Bureau of Labor Statistics. - Adjustment for potential TIPS illiquidity using: ratio of primary dealer nominal Treasury transaction volumes to TIPS volumes; bid-ask spreads of TIPS relative to nominals; TIPS yield fitting error from the Nelson–Siegel–Svensson model. - Key results: - Expected inflation over the next five years has recovered significantly from the March 2020 trough and is currently hovering within the 2.0–2.5 percent range, slightly above the average level prevailing over 2018–2019. - Expected inflation over the 5yr5yr segment has recovered somewhat but is currently just below pre-pandemic levels; recovery is more sluggish compared with the 5-year horizon. - The near-term (5-year) expected inflation is slightly above the longer-term (5yr5yr) horizon. - TIPS are CPI-indexed; near-term moves in expected inflation and breakevens partly reflect the recent sharp spike in oil prices, but adjusting for oil price impact does not meaningfully alter trajectories since March 2020. - The IRP for both 5-year and 5yr5yr breakeven decompositions has turned positive and is currently at a multi-year high. - From end-March 2020 to end-March 2021: - About 45 percent of the increase in liquidity-adjusted 5-year breakeven is due to an increase in the IRP for that tenor; the remaining 55 percent is due to an increase in the expected inflation component. - For the 5yr5yr, close to 10 percent of the increase is an increase in expected inflation and 90 percent is attributable to an increase in risk premiums. - Comparing trough-to-peak periods: - June 2016–June 2017: relative contributions of IRP and expected inflation to the increase in breakeven were similar at the 5yr5yr horizon; for the 5-year the bulk was due to change in expectations with about 15 percent attributable to increased IRP. - October 2008–October 2009: rise in expected inflation was a significant contributor to increased breakeven at both near- and longer-term horizons. - ETF evidence: - Flows into inflation-protected bond ETFs have averaged 5 percent of assets under management over the last three months, compared with 1.5 percent over the last five years. ### Decomposition of US real yields - Real yield = risk-adjusted real yield + real-term premium as per equation (4) in the source. - Methodology: decomposition delivered via estimation of the joint nominal and real term structure model noted above. - Key results: - The 5-year real yield has remained low, even on a risk-adjusted basis, with a slight uptick in the real-term premium in recent months. - Compression of real yield at the 5-year horizon reflects intended near-term effects of ultra-accommodative monetary policy, given higher near-term inflation expectations and policy rates near the zero-lower bound. - The 5yr5yr real yield increase has been more pronounced: - The risk-adjusted component for this tenor has increased somewhat. - The bulk of the increase is due to a rise in the real-term premium over the longer term. - The rise in 5yr5yr real yield largely reflects increased uncertainties around growth and the path of policy over the longer term, and may reflect concerns around large fiscal deficits and issuance needs and longer-term structural factors such as productivity and demographics. ### Inflation expectations from consensus surveys - Consensus Economics forecasts used to analyze very near term (1 year) and medium term (5 years) inflation expectations. - Findings: - Very near-term inflation expectations increased sharply since June 2020, ranging between 30–45 basis points across the major advanced economies. - Medium-term (5-year) changes have been relatively benign. - Latest consensus expectations indicate inflation is expected to remain broadly within the target range over the medium term. - Country ordering in latest near-term forecasts: United Kingdom highest, followed by United States, Euro Area, and Japan. ### Signals from inflation options - Inflation options (caps and floors) infer probability distributions around future inflation expectations using a methodology based on Black’s model as in Feldman et al. (2015). - Findings: - Inflation expectations increased steadily in the United States, with the probability distribution moving significantly to the right. - Market-implied probabilities of high inflation (>2 percent) increased sharply in both the United States and Euro Area; probability of low inflation (<1 percent) declined materially. - Structural differences: - Probability of high inflation in the United States is at almost 70 percent compared to 10 percent in the Euro Area. - Probability of low inflation in the Euro Area is still relatively high at 30 percent, while in the United States it is almost negligible. - Over the longer horizon, the probability of low inflation (<1 percent) in the United States is at historical lows and has corrected sharply from the peak of the COVID-19 sell-off. - The probability of low inflation has declined in the Euro Area but remains higher than 2018 troughs, indicating notable downside risks. *IMF | Monetary and Capital Markets — content as provided in the source document.* ### CONCLUSION AND POLICY IMPLICATIONS ### CONCLUSION AND POLICY IMPLICATIONS ### Decomposition of rise in nominal bond yields - Analysis attempts to decompose the sharp rise in the United States and other major advanced economy nominal bond yields into constituent drivers, specifically inflation expectations and real yields. ### Findings on inflation expectations - US inflation expectations appear to be well-anchored over the longer term. - There is evidence of a transitory increase expected over the near-term horizon in the United States. - For the Euro Area, the United Kingdom, and Japan, inflation expectations appear to be displaying a meaningful increase over both the near- and longer-term horizons. - Near-term expectations have risen somewhat more prominently in these economies, potentially reflecting “base ef f ects” in inflation measurement, as the recovery gains traction with re-opening of these economies. - The difference in near- versus longer-term dynamics of US inflation expectations can be considered in line with the Federal Reserve’s new objective of allowing inflation to moderately overshoot its target for some time. ### Findings on real yields and monetary policy stance - Taken together with significant monetary stimulus with the overnight policy rate essentially held at zero, the finding of negative expected real yields over the horizon of next few years suggests investors expect US monetary policy conditions to remain highly accommodative over the near term. - The short end of the yield curve appears well-anchored due to the Federal Reserve’s forward guidance on the path of rates and conditions that need to be met before considering a liftoff. - The longer end of the curve is also meaningfully affected by the Federal Reserve’s asset purchases program. - Asset purchases operate via the compression of risk premiums, supporting risky asset prices and easing broader financial conditions. - Evidence of a rise in real risk premiums over the longer term— that is, at the 5yr5yr forward horizon—can be interpreted as a potential reassessment of the outlook for, and the risks surrounding, asset purchases, taking into account the expected increase in Treasury supply related to fiscal support in the United States. ### Policy challenges and recommendations for the Federal Reserve - There is a wide range of views among market participants regarding the outlook for asset purchases, as well as uncertainty about the parameters of the Federal Reserve’s new Average Inf lation Targeting Framework. - An important challenge for the Federal Reserve, once the beginning of the policy normalization process draws closer, will be to provide clear and well-telegraphed communication about the pace of future asset purchases—and the reaction function more generally–—to avoid unnecessary volatility in financial markets. ### Risks, welcome developments, and IMF baseline - A gradual increase in longer-term US rates—a reflection of the expected strong US recovery—is heathy and should be welcomed. - A gradual increase would also help contain unintended consequences of the unprecedented policy support required by the pandemic, such as stretched asset prices and rising financial vulnerabilities. - The IMF’s baseline expectation is one of continued accommodative financial conditions, even if US rates were to rise further. - However, an abrupt tightening of global financial conditions remains a risk. - Given the asynchronous and multispeed nature of the global recovery, fast and sudden increases in US rates could lead to significant spillovers around the world, tightening financial conditions in emerging markets and disrupting their recovery process. *CONCLUSION AND POLICY IMPLICATIONS — gsnea2021003* --- _Source: https://www.imf.org/-/media/files/publications/gfs-notes/2021/english/gsnea2021003.pdf_