Interest rates

It is possible to separate the 10 year nominal treasury yield into its components.

There’s the real interest rate (average expected future short rates, essentially where monetary policy is expected to go), plus expected inflation, plus a term premium, which is a catch all for risks not associated with the path of policy (e.g. it will encompass supply and demand for treasuries, how the market values the “insurance” like aspect of treasuries, and so forth).

Once we remove those risk premia and inflation expectations from the 10 year yield, we can get at this “real risk neutral” rate, and further, we can note how it varies procyclical with the output gap (the difference between where the economy is producing, and where it could be producing, given the available stock of labour, capital, and technology).

In turn, we can pop that into a little model to say if the economy has recovered, from COVID, such that the output gap is zero (back to normal) where should the interest rate be?


And that number is around 1.1%. Currently (the pink dots) the rate is deeply depressed below where we think it should be.

Well, maybe we should temper that, it is ~1% below where we think it should be.

Add in inflation at target, and you can get a 3% treasury yield.

At the very least, coming back to our current 10 year yield, which is around 1.4%, you can see why we think it should move towards 2.25-2.5%, once we are done with Omicron (or once it is done with us).


Now it is hardly the sort of backup in rates that tanks the market, but it is enough, we think, to make present valuations for secular growth narratives look overcooked.

By that we mean pizza businesses that trade on 50x, the same multiple as plasma fractionators. That sort of thing.

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