The Federal Reserve (Fed) has increased the Fed Funds rate by 125 basis points or 1.25% since 2015, which had little effect on bonds until recently. Of late, however, yields on longer-maturity bonds have begun to rise, contributing to anxiety in the equity markets.

The current narrative from Wall Street and the media is that higher wages, better economic growth and a weaker dollar are stoking inflation. These forces are producing higher interest rates, which negatively affects corporate earnings and economic growth and thus causes concern for equity investors. We think there is a thick irony that, in our over-leveraged economy, economic growth is harming economic growth.

Despite the obvious irony of the conclusion, the popular narrative has some merits. Fortunately, the financial markets provide a simple way to isolate how much of the recent increase in longer-term bond yields is due to growth-induced inflation expectations. Once inflation is accounted for, we shine a light on other factors that are playing a role in making bond and equity investors nervous.

Given the importance of interest rates on economic growth and stock prices, understanding the supply and demand for interest rates, as laid out in this article, will provide benefits for those willing to explore beyond the headlines.

Nominal vs. Real

Since September of 2017, the yield on the five-year U.S. Treasury note has risen 90 basis points while the ten-year U.S. Treasury note has increased 75 basis points. At the same time, inflation, as measured by annual changes in CPI, declined slightly from 2.20% to 2.10%. Recent inflation data, while important in understanding potential trends, is by definition historical. As such, forecasts and expectations for inflation over the remaining life of any bond are much more relevant.

Treasury Inflation Protected Securities (TIPS) are a unique type of bond that compensates investors for changes in inflation. In addition to paying a stated coupon, TIPS also pay holders an incremental coupon equal to the rate of inflation for a given period. In technical parlance, TIPS provide a guaranteed real (after inflation) return. Non-TIPS, on the other hand, provide a nominal (before inflation) return. The real returns on bonds without the inflation protection component are subject to erosion by future rates of inflation. To gauge the market’s expectations for inflation, we can simply subtract the yield of TIPS from that of a comparable maturity nominal bond.

During the same six month period mentioned above, yields on five and ten-year TIPS increased 30 basis points. As shown below, this means that 60 basis points of the 90 basis point increase in the five-year note and 45 basis points of the 75 basis point increase in the ten-year note are a result of non-inflationary factors. The graphs below highlights the recent period in which five and ten-year yields rose at a faster pace than inflation expectations.