Break-evens vs real rate changes tell us about market regime

 

Where are we in the economic cycle? Where have we been? Where are we going? Simple questions that often don't have easy answers. A simple approach is to look at the 2x2 chart relating 10-year Treasury real yields and change in the breakeven inflation rate. During economic expansion real yields should increase. In a recession, real yield will decline from slack as well as looser monetary policy. In an improving (deteriorating) or expansionary (recession) economy, inflationary expectations should be increasing (decreasing). Combining these two market-based economic measures creates a simple 2-dimensional matrix. 

If real rates and inflation break-evens are rising, the economic should be in strong expansion. If real rates and inflation expectations are both falling, the economy is likely in a recession. The II and IV quadrants of the 2x2 diagram represent transitioning environments; improving or tapering. Tracking this combination over the last 5 years using 3-month changes for inflation breakevens and 3-month averages for real rates shows how the economy has moved from recession to crossing into expansion. 

The expansion phase tells investors it is still worth holding risky assets such as equity growth and reducing exposure in safe assets such as bonds.