Understanding the Rise in Long-Term Rates

IMF Blog, April 22, 2021

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Understanding the Rise in Long-Term Rates

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Bibliographic details

• Authors: Tobias Adrian, Rohit Goel, Sheheryar Malik, Fabio Natalucci
• Published: April 22, 2021

Overview

• The nominal yield on the benchmark 10-year Treasury has increased about 70 basis points since the beginning of the year.
• The increase partly reflects an improving US economic outlook amid strong fiscal support and the accelerating recovery from the COVID-19 crisis.
• Other contributing factors include investors’ concerns about the fiscal position and uncertainty about the economic and policy outlook, which may help explain the rapid increase early in the year.
• Because US bonds are the basis for fixed-income pricing and affect almost any security around the world, a rapid and persistent yield increase could result in a repricing of risk and a broader tightening in financial conditions, triggering turbulence in emerging markets and disrupting the ongoing economic recovery.

Dissecting yield moves

• A 10-year US Treasury yield can be decomposed into:
  • real Treasury yield (a proxy for expected economic growth),
  • inflation breakeven rate (a measure of investors’ future inflation expectations).
• Real yield plus breakeven inflation equals the nominal rate.
• Breakeven rates and real yields include both market expectations and risk compensation:
  • inflation risk premium — related to future inflation uncertainty;
  • real risk premium — reflects uncertainty about the future path of interest rates and economic outlook.
• The sum of inflation risk premium and real risk premium is commonly referred to as the term premium, representing compensation required by investors to bear interest-rate risk embedded in Treasury securities.
• The 10-year yield can be usefully split into two horizons:
  • the 5-year yield (shorter-term),
  • the "5-year-5-year forward" (covering the second half of the bond’s 10-year maturity).
• Recent developments:
  • The recent increase in the 5-year yield has been driven by a steep rise in short-term breakeven inflation, linked to rising commodity prices, global recovery traction, and the Federal Reserve’s reiterated intention to maintain an accommodative monetary policy stance.
  • 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.
• Interpretation:
  • The rise in the 5-year inflation breakeven reflects an increase in both expected inflation and inflation risk premia.
  • The sharp rise in the longer-term real yield is primarily due to a higher real risk premium, pointing to greater uncertainty about the economic and fiscal outlook, the outlook for asset purchases by the central bank, and longer-term drivers such as demographics and productivity.

Implications for monetary policy

• Current stance and expectations:
  • Monetary policy remains highly accommodative, with sharply negative real yields expected in coming years.
  • The overnight policy rate essentially at zero, combined with the Federal Reserve’s indication that it will allow inflation to moderately overshoot its inflation target for some time, provides significant monetary stimulus 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.
• Role of asset purchases:
  • Asset purchases operate via compression of risk premia, supporting risky asset prices and easing broader financial conditions.
  • 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.
• Forward guidance:
  • Forward guidance about the path of policy rates and the strategy about asset purchases has played a crucial role during the pandemic.
  • While the path of short-term interest rates appears to be well understood, there is a wide range of views among market participants about the outlook for asset purchases.
  • It is crucial that the Federal Reserve, once the beginning of the policy normalization process draws closer, provides clear and well-telegraphed communication about the pace of future asset purchases to avoid unnecessary volatility in financial markets.
• Policy stance on rate moves:
  • A gradual increase in longer-term US rates—a reflection of the expected strong US recovery—is heathy and should be welcomed.
  • A gradual rise would help contain unintended consequences of unprecedented policy support, such as stretched asset prices and rising financial vulnerabilities.

Risks and global implications

• The IMF’s baseline expectation is one of continued easy financial conditions, even if US rates were to rise further.
• Risks:
  • A 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 across the world, tightening financial conditions for emerging markets and throwing a wrench in their recovery process.

Source: IMF blog post "Understanding the Rise in Long-Term Rates" (April 22, 2021).