Inflation risk is topical again, as I’ve been discussing this week. As a result, the bond market is demanding a higher yield premium to compensate for the possibility that inflation will be higher than recently expected.
The question for investors: Does the runup in Treasury yields to date suffice, given the current inflation expectations? In the first of a series of new indexes to help shed light on an answer, here’s a look at CapitalSpectator.com’s US 5-Year Yield Opportunity Index (YOI).
The concept is to compare the nominal 5-year Treasury yield against an index of market-based inflation expectations and a model run by the Cleveland Fed. The spread provides a measure of the relative appeal of the current 5-year rate. To measure inflation expectations that align with the 5-year maturity I’m using three data sets: 5-Year Breakeven Inflation Rate, 5-Year, 5-Year Forward Inflation Expectation Rate, and a model of 5-Year Expected Inflation.
The current YOI reading shows a relatively high spread in the 5-year yield over the average of the three estimates of future inflation: nearly +2.1 percentage points as of Jan. 9.
Does a +2.1 spread currently available in a nominal 5-year Treasury yield compensate for today’s five-year inflation forecast? There’s room for debate, always, primarily because the future’s always uncertain. What we can say with confidence is that the premium at present is relatively high vs. recent history. As recently as September the spread was a sharply lower +1.3 percentage points. By that standard, the market’s offering a comparatively better deal these days.
Note that you can also earn a 2.0% real yield at the moment in an inflation-indexed Treasury (i.e. a 5-year TIPS). In effect, a nominal 5-year and an inflation-indexed 5-year yield are competitive. But that’s not always the case. In a future article I look at how the two Treasury yields available to investors compare through time with an eye on spotting opportunities in one vs. the other.