One term spread steepened sharply; only one spread actually reversed. The five-year inflation breakeven point is falling. And the risks are rising.
figure 1: The 10-month three-month Treasury bond spread (blue) and the 10-year two-year spread (red), both expressed as a percentage. Source: FRB Calculations from FRED, Treasury and the authors.
Spreads have increased recently, so the average 12-month-ahead probabilistic model’s peak recession probabilities in August 2023 are 31% and 39%, respectively.
If a simple calculation using unadjusted Treasury bonds and TIPS (5-year term) is used, the inflation breakeven has experienced a staggering decline. However, after adjusting for risk and liquidity premiums, we see a different story – although the conclusions are broadly the same.
figure 2: The five-year inflation breakeven is calculated as the five-year Treasury yield minus the five-year TIPS yield (blue), and the five-year breakeven is adjusted by the inflation risk premium and the liquidity premium per DKW (red), both in %. Source: FRB via FRED, Treasury, KWW Following D’amico, Kim and Wei (DKW) access 9/7, and author’s calculations.
Expected inflation over the 5-year period has averaged around 2.3-2.4%, but the adjusted series shows a continued slow rise since Russia’s expanded invasion of Ukraine.
What about perceived risk? The VIX and traditional bond spreads — Moody’s BAA-10-year Treasury spread — are in step. The last peak of the SP500 occurred until mid-August.
image 3: BAA – 10-year Treasury bond spread, % (red, left scale), VIX (yellow-green, right scale). Sources: Federal Reserve, CBOE, via FRED, and author’s calculations.
Since then, the VIX has risen as the stock market has fallen. Currently, the heightened awareness of risk is limited to the stock market.
