It’s about earnings, not Treasury yields

A close look at the behavior of US government yields suggest that a big jump in interest rates is unlikely. Given the strength of the US economy, the rise in yields to date has been quite modest and is likely to remain so. That runs against the conventional wisdom that the threat of rising bond yields is responsible for the stock market correction.

There are two components to the 10-year US Treasury yield, and it is helpful to look at them separately. The first is the “real,” or inflation-indexed yield, namely the yield of Treasury Inflation Protected Securities, or TIPS. The second component is the difference between the TIPS yield and the nominal Treasury yield. That is called breakeven inflation, because it represents the inflation rate at which holders of inflation-indexed Treasuries and nominal Treasuries will break even.

Breakeven inflation moves closely with the oil price. But the relationship between breakeven inflation and the oil price has shifted over the past 14 months, as we see in the chart below. For every increment in the oil price, breakeven inflation has risen less in recent months than it did in the past. That does not suggest a violent breakout of Treasury yields, even if oil prices were to move higher.

The yield on TIPS moves in a more or less straight line with the expected federal funds rate 12 months out, that is, with the market’s view of what the Federal Reserve will do over the next year. In fact, it moves in a series of lines: the lines keep shifting to the left in the chart below, which says that for every expected increment in the Federal Reserve’s overnight rate, inflation-protected securities have risen less than they did in the past.

Both the inflation and the inflation-indexed components of Treasury yields have been less sensitive to their determinants (oil and the expected fed funds rate) in recent months. That augurs for a gradual and limited rise in interest rates, rather than a disruptive change.