Rates: The twilight zone

The outlook for inflation is a key factor underpinning interest rate policy decisions. That outlook can be derived from forecasts, but it can also come from the market discount.

Billions if not trillions of dollars underpin that discount, typically with long-term investments. Right now that market discount is quite remarkable - the US 10yr breakeven inflation rate is at a mere 1.5%. This is remarkable as it is so low. It is telling us that US inflation will average just 1.5% per annum over the coming decade. While the ECB could only dream of such a discount, for the US, this is an exceptionally low inflation expectation at the tail end of a cycle upswing.

This tame discount for inflation is all the comfort that the Federal Reserve needs when it comes to pulling the rate-cut trigger. Market rates are impacted in a similar manner. Swap rates or conventional yields are nominal in nature. In other words, they consist of a real rate plus an inflation expectation.

Think about this for a moment. A US 10yr real yield at zero or lower paints a very poor picture for the future; it implies, at best, very subdued growth prognosis. And that's for the US, where things have been relatively rosy in recent years

In simplistic terms, if the US 10yr rate is at 1.6% and the breakeven inflation rate is 1.5% then the implied real yield is about 10bp (as can be gleaned from inflation-protected Treasury yields). A few weeks back the 10yr real yield had, in fact, turned negative. While moderately positive now, further compression of nominal yields lower would likely force 10yr real yields back into negative territory.

Think about this for a moment. A US 10yr real yield at zero or lower paints a very poor picture for the future; it implies, at best, a very subdued growth prognosis. And that's for the US, where things have been relatively rosy in recent years. In Europe, the 10yr inflation breakeven is 0.75%, and nominal core yields are negative right out to 30yrs. Moreover, if nominal yields are negative, then by definition real yields are even lower. And they are; trading at a staggering -1.2% for 30yr Germany. The only silver lining here is there is an implied 30yr breakeven inflation rate of 1.3% underpinning that. But that's of little comfort.

No wonder the ECB is worried. They are all in, and practically begging governments to loosen fiscal policy - anything to steer the eurozone away from the abyss

No wonder the ECB is worried. They are all in, and practically begging governments to loosen fiscal policy - anything to steer the eurozone away from the abyss. Whisper it quietly, but within that abyss lies a eurozone existential risk scenario that needs to be steered well clear of. While the discount from the US is one of mediocre growth, the discount from Europe, on the face of it, is for depression. Let's be clear, we are not calling for that. But the market discount is consistent with it (notwithstanding bond market supply/demand/QE dynamics).