Economists project US annual average inflation of 2.3% over the next 10 years, according to the Survey of Professional Forecasters conducted by the Federal Reserve Bank of Philadelphia. Assuming that this is representative of wider market expectations, the current 10-year Treasury yield of 3.4% implies a real interest rate of only 1.1%.
The first chart shows a long-term history of this real yield measure (i.e. the 10-year Treasury rate minus economists' 10-year inflation forecast)*. The current 1.1% compares with a median real yield since 1953 of 2.6%. This suggests that the nominal 10-year yield would need to rise from the current 3.4% to 4.9% to represent "fair value" by historical standards, assuming no change in inflation expectations.
Such an increase is unlikely to be triggered by the end of QE2, which is fully discounted. A more probable source of upward pressure is a strengthening of corporate credit demand as economic recovery continues, resulting in a clash with government financing needs. Growth in corporate credit market debt outstanding rose from 4.5% to 5.5% annualised between the first and second halves of 2010, according to the flow of funds accounts.
While overall borrowing firmed, companies continued to repay bank credit during the second half. This has changed in early 2011, with banks' commercial and industrial loans rising at a 6.3% annualised pace in the first three months and by 11.3% in March alone – second chart. Stronger credit demand alongside increased hiring and M&A is evidence of a return of corporate "animal spirits", in turn suggesting rising risks for Treasuries.
* The 10-year inflation forecast in the Survey of Professional Forecasters starts in 1991. An equivalent measure from The Blue Chip Economic Indicators survey was used over 1979-91. For earlier years, expectations were proxied as a function of actual inflation.
