Messages from the Market

One term spread steepens sharply; only one spread has actually inverted. The five year inflation breakeven is falling. And risk is rising.

Figure 1:  Ten year-three month Treasury spread (blue), ten year-two year spread (red), both in %. Source: FRB via FRED, Treasury, and author’s calculations.

Spreads have increased recently, so peak recession probabilities from plain vanilla 12 month ahead probit models are 31% and 39% for August 2023.

Inflation breakevens have experienced a startling descent, if calculated naively using unadjusted Treasurys and TIPS (at 5 year horizon). However, after adjusting for risk and liquidity premia, we see a different story — although the conclusion is much the same.

Figure 2:  Five year inflation breakeven calculated as five year Treasury yield minus five year TIPS yield (blue), five year breakeven adjusted by inflation risk premium and liquidity premium per DKW (red), both in %. Source: FRB via FRED, Treasury, KWW following D’amico, Kim and Wei (DKW) accessed 9/7, and author’s calculations.

Expected inflation over the 5 year horizon averages around 2.3-2.4%, but the adjusted series shows a slower constant ascent since the expanded Russian invasion of the Ukraine.

What about perceived risk? The VIX and a conventional bond spread — Moody’s BAA-10 year Treasury spread — moved in lockstep. Until mid-August, when the last peak in the SP500 occurred.

Figure 3:  BAA-ten year Treasury spread, % (red, left scale), VIX (chartreuse, right scale). Source: Fed, CBOE, via FRED, and author’s calculations.

Since then, the VIX has risen as equity markets have declined. Increasing perception of risk is for the moment localized to the equity market.