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Concerns over stagflation return On the surface, this has been an uneventful year for the US rates market so far. At the start of January, the market was pricing two Fed hikes for the year. Six weeks later, the market is still pricing only two Fed hikes for the year. The yield on the bellwether 10y US Treasuries started the year at 2.44%. Six weeks later, it is at 2.41%, unchanged for all practical purposes. As usual, the surface view is deceiving. The seeming collapse in volatility belies the dramatic changes in the composition and term structure of rates. Since the December FOMC meeting, real yields and inflation breakevens have diverged in remarkable fashion. Year to date, 5y real yields have declined by 16bp while 5y inflation breakevens have risen by 12bp (Chart 1); the 5s-30s real curve is 10bp steeper while the breakeven curve is 10bp flatter. Chart 1: 5y real yields and 5y inflation breakevens (%) 2.5 2 1.5 1 0.5 0 0.5 10/1/2016 © 10/26/2016 += 11/20/2016 += 12/15/2016 + —-1/9/2017 2/3/2017 == 5y real yields (%) = ===5y infl BE (%) Source: BofA Merrill Lynch Global Research The effect of the divergence between real yields and inflation breakevens has been felt across financial markets. For example, the USD, which trades with real rather than nominal yields, has declined in tandem with real yields (Chart 2). In contrast, gold, which usually thrives on inflation concerns, has been surging lately. Chart 2: DXY and 5y real yields (%) Chart 3: 5y real yields versus 5y inflation breakevens (%) 104 0.3 4 103 0.2 102 04 3 101 0 2 0 04 { E1 2 OT QE3 98 Oe 0 97 -0.3 96 -0.4 “1 95 -0.5 -2 94 -0.6 3 10/1/2016 = 11/1/2016 = 12/1/2016 ~— 1/1/2017 2/1/2017 3/1/2009 3/1/2010 3/1/2011 3/1/2012 3/1/2013 a==——DXY (LHS) 9 -===5y real yields (RHS) a= 5y real yields (%) = ====5y infl BE (%) Source: BofA Merrill Lynch Global Research Source: BofA Merrill Lynch Global Research We have seen price action like this before. Indeed, it was quite common during the QE period (Chart 3). However, QE is neither on the horizon nor on investors’ minds right now. So what is really going on? Under normal circumstances, inflation breakevens are a reflection of investors’ inflation expectations while real yields a proxy for their growth 2 Cause and Effect | 13 February 2017 BankofAmerica <2” Merrill Lynch HOUSE_OVERSIGHT_014722