While the DKW model is imperfect, it provides some context around which factors are driving Treasury rates higher.
The DKW model was recently updated for EoM January.
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To start, as I have commented many times in the past, the economy is in a clear cyclical upturn, so we should expect the vector or direction in both growth expectations and inflation expectations to move higher.
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However, embedded within a 10-year rate is 10-year assumptions, not easily moved like Y/Y CPI or growth. These are long-term, slow-moving averages.
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The expected real short-term rate is the closest proxy for long-term real growth expectations in the DKW model
The actual number is not as important to me as the direction
There was a major decline upon the pandemic which makes sense as LT trend growth was badly impacted.
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Directionally, the market is saying (based on DKW) that long-term trend growth is still in the toilet.
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Actual inflation expectations (different than breakevens) are highly consistent with the cyclical upturn in inflation indicators.
As noted, we should expect a directional increase and we are seeing that in the DKW model of expected inflation (10YR avg).
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The vector, or direction, makes complete sense and is consistent with economic indicators. The magnitude of the increase is far less than popular breakevens which makes some people uncomfortable.
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The largest swing factor driving breakevens to the moon is the liquidity premium.
This is the most controversial factor in the DKW model and in all similar models.
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It is hard to assess the real liquidity premium but essentially, the DKW model is suggesting that extraordinary factors, such as the Fed gobbling 15% of the TIPS market, are contributing to the rise in breakevens more than the rise in truly expected inflation
For me, the main point is that yes, growth and inflation expectations are rising, as they should be, given the upturn in growth/inflation indicators, but that the reflation narrative is getting extra support from other factors like the Fed.
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The DKW model is helpful in separating something that I have written about: secular vs. cyclical trends.
The DKW model, imperfect as it is, confirms that long-term (secular) trends are badly damaged and not recovering while cyclical trends are turning higher, with added firepower from factors like the Fed.
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12/12
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There is a battle between long-term (secular) disinflation and a short-term cyclical rise in industrial-based inflation
The market is desperately hoping the cyclical inflation wins, and it still has the edge for now, but not this month
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⚠️ Warning ⚠️
In the next few months, the base effect will boost inflation big time and it will be consistent with the cyclical upturn in inflation, but the CPI growth will fade after the easiest comp.
That aside...
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Headline CPI edged slightly higher in year over year growth rate terms but remains stubbornly low, and way too low based on breakeven rates.
Headline inflation ticked up slightly and is mostly a balancing act between rising goods inflation and falling services inflation.
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Goods inflation continues to rise, jumping to nearly 4% on a year over year basis.
Goods inflation (and industrial commodities) are rising due to manufacturing backlogs caused by shutdowns and the overall shift to at-home goods consumption and away from services consumption.
This is because of a sudden & forced shift to at home goods consumption that caught everyone offsides
The restocking upturn is set to continue
Once the industrial upturn runs it's course, we'll be back to the same old trends
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There's been a secular trend of services consumption growing faster than goods consumption.
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That trend shifted suddenly but is unlikely to last for years after the economy re-opens. This shift is likely temporary and a result of forced lockdowns, fear of consumer-facing businesses, etc.
Long-term expectations do not change as frequently as daily market fluctuations would make it seem.
A quick update on Treasury rates through the lens of the DKW model
*As of Dec. 31*
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In previous threads, I made the distinction between long-term secular trends in growth and inflation and shorter-term (2-6 quarters) trends in nGDP growth
Right now, the long-term trends are unaltered because long-term trends just don't change that fast but we have a very strong cyclical upturn in the economy, centered primarily on the shift to goods consumption bolstering the manufacturing sector and industrial commodities.