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.
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
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.