I love your work, Peter. The next natural question for me is: how does this whole analysis reconcile with long-term inflation breakevens being where they currently are (10Y 2.25%, 30Y 2.18% in US TIPS, almost identical in Australia)? The nominal yield curve steepener does make sense, macro-economically speaking, but why is the term premium entirely embedded in the real yield component, while the implied inflation term structure is not just very low but actually downward-sloping? If soft default via inflation is the way out of the debt spiral, shouldn’t it be the other way around? For me, this is the most inexplicable conundrum in current macro, and I’d very much appreciate your thoughts on it.
I don't think soft default is a way out per se. It doesn't really reduce the nominal burden, but is instead just a transfer from bondholders to others in the economy. This doesn't create any net economic value. No different to a corporate default in that sense, it's just a tax on bondholders.
Your real and nominal curves are telling you what the market expects - inflation falls while the Fed doesn't cut too much which leaves reals elevated. Again it is prescribing little risk to another explosion in inflation like in 2021. That view is probably fair but underprices the tail event of another demand-side crunch occurring.
The ultimate lesson here is that the bond market is really bad at pricing inflation tail events!
Sure, thanks for your reply and agree with all that. The problem we are left with, as I see it, is that the forward real yields implied by the current unusually steep real yield curve(s) are just not realistic. A 10Y-into-20Y real yield of ~3.00%, for example, which is what the US TIPS curve is pricing in, would blow up any future debt sustainability analysis, if realised. Would you agree?
In this case I would say the upward sloping real yield curve is the driver of declining forward breakevens, rather than the other way around. I.e. the predominate view is that forward inflation is declining, therefore reals must be increasing.
Also remember GDP is turning over at a 3.5%+ so it isn't totally out of whack to see high real yields
Sure, but the real GDP run rate is the result of a large primary deficit (inflationary and Debt/GDP accretive); what would real GDP growth be if primary balances were run? My contention is that the nominal yield curve and the BEI curve are pricing in scenarios that are possible but mutually exclusive. Something will eventually have to give, and in my opinion that can only be lower real yields, whichever the main driver is.
What you have said is fair, and chances are it is in the breakeven curve which is wrong.
I did describe how this pricing came about in the article however - the strong belief that imported deflation will be stronger than service inflation effects. This in itself is also a situation in which something "eventually has to give" as the Chinese enable this deflation through debt accretion of their own!
That’s a very interesting point, which I hadn’t fully appreciated reading your post. So, the market (momentarily) believes that global deflationary forces will prevail, and yet demands significant term premium from the nominal yield curve. For fiscal irresponsibility alone, basically, hence the steep real yield curve and inverted BEI. I do agree that the BEI curve is most likely where the mispricing is (i.e. it will have to reprice significantly higher), but receiving the long-end real yield remains imho the best way to play that view, especially in non-USD currencies such as AUD and NZD, at their current levels of ~3.00% and above.
Reading this from Argentina so very much agree with the dynamics of a soft default (not even mentioning hard ones!). In a closed economy with capital restrictions, winners have long been local industrialists whose prices have always outpaced inflation and benefitted from little to no competition from intl' markets.
I think the US might have a tougher time making investors forget about their latest soft default. As you rightly mention Peter, it took a multi-decade rally to gain back their reputation, so I don't see a clear path given the political willingness to do anything about it.
You do address this, but one has to wonder how much runway there is for "China... to continue to deflate export prices."
A huge fraction of secondary sector output is plowed into capital formation, underwritten by the implicit central government guarantee of manufacturing enterprise debts and a bunch of transfers. How long can those debts and transfers continue to allow capital accumulation wildly in excess of what domestic workers/consumers need or could utilize?
I love your work, Peter. The next natural question for me is: how does this whole analysis reconcile with long-term inflation breakevens being where they currently are (10Y 2.25%, 30Y 2.18% in US TIPS, almost identical in Australia)? The nominal yield curve steepener does make sense, macro-economically speaking, but why is the term premium entirely embedded in the real yield component, while the implied inflation term structure is not just very low but actually downward-sloping? If soft default via inflation is the way out of the debt spiral, shouldn’t it be the other way around? For me, this is the most inexplicable conundrum in current macro, and I’d very much appreciate your thoughts on it.
Thanks! To your question.
I don't think soft default is a way out per se. It doesn't really reduce the nominal burden, but is instead just a transfer from bondholders to others in the economy. This doesn't create any net economic value. No different to a corporate default in that sense, it's just a tax on bondholders.
Your real and nominal curves are telling you what the market expects - inflation falls while the Fed doesn't cut too much which leaves reals elevated. Again it is prescribing little risk to another explosion in inflation like in 2021. That view is probably fair but underprices the tail event of another demand-side crunch occurring.
The ultimate lesson here is that the bond market is really bad at pricing inflation tail events!
Sure, thanks for your reply and agree with all that. The problem we are left with, as I see it, is that the forward real yields implied by the current unusually steep real yield curve(s) are just not realistic. A 10Y-into-20Y real yield of ~3.00%, for example, which is what the US TIPS curve is pricing in, would blow up any future debt sustainability analysis, if realised. Would you agree?
In this case I would say the upward sloping real yield curve is the driver of declining forward breakevens, rather than the other way around. I.e. the predominate view is that forward inflation is declining, therefore reals must be increasing.
Also remember GDP is turning over at a 3.5%+ so it isn't totally out of whack to see high real yields
Great article!
I just say that ultimate top prize in competitive defaulting proudly belongs to Russia, which managed to default AND devalue at the same time in 98
Sure, but the real GDP run rate is the result of a large primary deficit (inflationary and Debt/GDP accretive); what would real GDP growth be if primary balances were run? My contention is that the nominal yield curve and the BEI curve are pricing in scenarios that are possible but mutually exclusive. Something will eventually have to give, and in my opinion that can only be lower real yields, whichever the main driver is.
What you have said is fair, and chances are it is in the breakeven curve which is wrong.
I did describe how this pricing came about in the article however - the strong belief that imported deflation will be stronger than service inflation effects. This in itself is also a situation in which something "eventually has to give" as the Chinese enable this deflation through debt accretion of their own!
That’s a very interesting point, which I hadn’t fully appreciated reading your post. So, the market (momentarily) believes that global deflationary forces will prevail, and yet demands significant term premium from the nominal yield curve. For fiscal irresponsibility alone, basically, hence the steep real yield curve and inverted BEI. I do agree that the BEI curve is most likely where the mispricing is (i.e. it will have to reprice significantly higher), but receiving the long-end real yield remains imho the best way to play that view, especially in non-USD currencies such as AUD and NZD, at their current levels of ~3.00% and above.
https://fraser.stlouisfed.org/files/docs/publications/FRB/pages/1985-1989/32252_1985-1989.pdf
Reading this from Argentina so very much agree with the dynamics of a soft default (not even mentioning hard ones!). In a closed economy with capital restrictions, winners have long been local industrialists whose prices have always outpaced inflation and benefitted from little to no competition from intl' markets.
I think the US might have a tougher time making investors forget about their latest soft default. As you rightly mention Peter, it took a multi-decade rally to gain back their reputation, so I don't see a clear path given the political willingness to do anything about it.
I agree...it just reduces the discretionary allocation towards bonds.
The thing is that the mandatory allocation is only growing bigger!
You do address this, but one has to wonder how much runway there is for "China... to continue to deflate export prices."
A huge fraction of secondary sector output is plowed into capital formation, underwritten by the implicit central government guarantee of manufacturing enterprise debts and a bunch of transfers. How long can those debts and transfers continue to allow capital accumulation wildly in excess of what domestic workers/consumers need or could utilize?