Bond yields, inflation, and more - BBH

In a recent report, BBH economists explain that US Treasury yields have fallen around 50 bp since the March rate hike and market-based measures of inflation, like the 10-year breakeven and the five-year/five years forward, have fallen around 35 bp over the same period.

Key quotes:

"That is to say that the decline in market-based measures of inflation expectations can account for nearly three-quarters of the decline in nominal yields." 

"It begs the question, why these inflation expectations have fallen.  Commodity prices in general, and oil prices, in particular, have fallen, and this coincides with a decline in inflation expectations."  

"While this is clearly part of the story, many narratives are stopping at this point.   It is fundamentally incomplete."  

"Let's begin with the basics.  The nominal yield is a function of a real yield and a premium.  In many high income countries, that premium is thought to be inflation.  The conventional narrative uses market-based measures of inflation expectations. There are some problems with the market-based measures."  

"One widely recognized problem is that there is a difference in liquidity between conventional bonds and inflation-protected securities.  This lends itself to breakevens falling an environment when bonds are rallying, increasing breakevens when bonds are being sold."  

"There are survey-based measures of inflation as well.  These are considerably more stable than market-based measures.  There are two surveys that have been cited by officials.  The first, and arguably the more important, is the survey the Fed conducts itself, the Survey of Professional Forecasters.  In May 2016, the average (2016-2020) was 2.1% and the 2.3% for a longer period (2016-2025).  Last month's survey resulted in an average of 2.35% and 2.30% (2017-2021 and 2017-2026 respectively."  

"The other survey is the University of Michigan's consumer sentiment survey.  The 5-10 year expectation was at 2.6% in June 2016.  The preliminary estimate for June 2017 was reported last week.  It was also at 2.6%.  The final estimate will be reported next week (June 30). Taken together and individually, the surveys suggest inflation expectations are considerably more stable than the market-based measures."