Today, we use an assortment of FRED data to consider a straightforward question: What has happened to the returns on safe assets (in this case, Treasury securities) since the pandemic hit? We look especially at the possible contributions of inflation expectations and demand for liquidity.

The FRED graph above shows

• nominal rates for the 1-year Treasury (dark blue) and the 5-year Treasury (red)
• the difference between the “instantaneous” 5-year-ahead Treasury rate and the 5-year, 5-year forward expected inflation rate (green)
• the difference between corporate bond yields and the 5-year Treasury yield (light blue)

The 1- and 5-year Treasuries are among the safest and most liquid assets in the market, and both rates have dropped considerably since the start of the pandemic. From January 2 to July 31, the 1-year rate fell 145 basis points from 1.56% to 0.11% and the 5-year rate fell 144 basis points from 1.67% to 0.23%. Also, the slope of the yield curve (the difference between the 5- and the 1-year rates) in July is quite similar to what it was in January: about 10 basis points.

Because these are shorter-term nominal rates, we also look at forward rates implied by the Treasury yield and long-term inflation expectations. Specifically, we graph the difference between the instantaneous Treasury rate 5 years forward and the 5-year, 5-year forward inflation expectation rate to calculate the change in long-term real rates. The green line in the graph shows a decline of about 108 basis points, smaller than the decline in short-term nominal rates.

Finally, we can look at what happened with safe but illiquid assets. The light blue line tracks the change in the credit spread for AAA corporate bonds (ie, the difference between ICE BofA AAA US Corporate Index Effective Yield and the 5-year Treasury). These securities carry very little default risk, but aren’t as liquid as Treasuries. So, the yield spread on these bonds relative to Treasuries is often viewed as a proxy for the liquidity premium. (See papers by Krishnamurthy and Vissing-Jorgensen and del Negro et al.) In recent months, this spread has risen by 32 basis points, consistent with the increased scarcity of liquid assets.

Hence, the drop in nominal rates for safe and liquid assets was driven by a combination of an overall drop in real and safe rates (at both short and long horizons) and an increase in the liquidity premium. A paper by Kozlowski, Veldkamp, and Venkateswaran provides a model consistent with these observations.

How this graph was created: Search FRED for “1 year Treasury” and select the constant maturity rate. From the “Edit Graph” panel, open the “Add Line” tab: Search for and add the 5-year rate. Then, add another line by searching for and selecting the “instantaneous rate” series (take the 5-years hence series); then add a series by searching for and selecting the forward inflation rate; fianlly, apply formula a-b. For the last line, repeat the previous steps by searching for “AAA yield” and “5 year Treasury.” Finally, start the sample period on 2020-01-01.

Suggested by Julian Kozlowski.