The drivers of higher US bond yields
Higher US bond yields reflect a higher expected future real short rate, the return of a real term premium & higher expected inflation.
With rising public-sector debt placing upward pressure on US government bond yields, the charts below show the Fed’s modelled split of the different drivers of the benchmark 10-year nominal bond yield.
The Fed estimates various liquidity, term and risk premia to get a cleaner read on expected inflation and real interest rates than the usual approach of approximating the real bond yield by using the TIPS inflation-indexed bond yield and estimating expected inflation using the breakeven inflation rate, derived as the gap between the nominal bond yield and the TIPS yield.
The main finding from the Fed’s split of the data is that nominal bond yields are higher over the past couple of years than pre-COVID experience because estimated real bond yields and expected inflation are both broadly back at pre-global financial crisis levels.
In turn, higher real bond yields reflect the estimated expected future real short rate and real term premium both returning to positive territory after fluctuating around zero for most of the time since the global financial crisis.
Taking rounded averages of monthly bond yields and their estimated drivers to illustrate these points, the average nominal bond yield over the past two years has almost doubled from the average over the two years prior to COVID, increasing by about 1¾pp from about 2½% to around 4¼%.
- The estimated real bond yield has increased by about 1¼pp from around ¼% to about 1½%, comprising a 1pp increase in the expected future real short rate from about ¼% to near 1¼% and a roughly ¼pp increase in the real term premium from zero to about ¼pp.
- The estimated expected inflation rate has also increased by about ½pp from around 2¼% to about 2¾% over this period (note that this is a measure of expected CPI inflation and hence exceeds the Fed’s 2% inflation target because CPI inflation is nearly always higher than PCE inflation). There is no real change in the estimated inflation risk premium over this time, which remains around zero.
The higher estimated expected real short rate is consistent with other market and survey-based indicators that suggest that the neutral policy rate has increased from pre-pandemic levels, partly because of the stimulus from easy fiscal policy, while the return of a positive real term premium is consistent with the end of QE, as well as record high public-sector debt.
With no sign that US fiscal policy will be brought under control any time soon, record levels of public debt raise the risk that real yields edge higher, placing upward pressure on nominal bond yields (expected inflation may not change unless consumers and firms start to believe that new tariffs will lead to higher ongoing inflation).
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Based in Sydney, Kieran Davies is Chief Macro Strategist at Coolabah Capital Investments, an asset manager with 40 executives and over $8 billion in fixed-income strategies. Kieran is responsible for macroeconomic research and investment strategy, contributing to the investment decisions of the firm. Kieran has long experience as a macroeconomist in both the private and public sectors. He has worked most recently as Chief Markets Economist for National Australia Bank and was previously Chief Economist, Australia and New Zealand, for Barclays Bank and ABN Amro Bank/RBS. Kieran also worked as Principal Adviser on the macroeconomy and budget policy in the Commonwealth Treasury and Director of Forecasting.
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Based in Sydney, Kieran Davies is Chief Macro Strategist at Coolabah Capital Investments, an asset manager with 40 executives and over $8 billion in fixed-income strategies. Kieran is responsible for macroeconomic research and investment strategy,...
Based in Sydney, Kieran Davies is Chief Macro Strategist at Coolabah Capital Investments, an asset manager with 40 executives and over $8 billion in fixed-income strategies. Kieran is responsible for macroeconomic research and investment strategy,...
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