The US two-year yield has risen nearly 57 bp so far this year. The Federal Reserve has hiked rates twice and is poised to raise the Fed funds target rate in a few weeks. The 10-year yield has fallen 11 bp. The decline in the 10-year yield seems counter-intuitive and many worries that if it continues, it may signal a recession. To be sure, the 2-10 year curve is still positively sloped by at 58 bp, but it is the flattest since late 2007.  

The short-end of the curve is anchored to a large extent by Fed policy and perceptions of its trajectory. Long-term rates have three components. The long-term expectations for real rates, inflation expectations, and the term premium, which includes everything else.  

To begin explaining the decline in the 10-year yield this year, it is helpful to consider the three components. Let’s start with the long-term expectation for the real rate. This is what economists have dubbed r-star (r*). It is something that is not observable, so economists have devised proxies. A useful proxy is long-term forecasts for Fed funds, which are then adjusted for the Fed’s inflation target.  

Consider that last December, the median forecast of Fed official of the long-term equilibrium rate for Fed funds was 3.0%. Assuming it makes reaches its inflation target (2%) that would put the real rate nearer 1%.  In the latest forecasts (September), the median Fed forecast now stands at 2.75%. Nearly half the decline in the 10-year yield this year could be explained by the lower long-term real rate expectation.  

The second component of long-term interest rates is the inflation expectation. There are two broadly different ways to document long-term inflation expectations: market-based measures and surveys. The market-based measures, like the breakeven rates (the difference between the yield of inflation-linked securities and conventional securities, or five-year forward forwards). The problem with these is that they are not clean and the implied yield is also a function of the relative supply and demand of these instruments.   

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