What a 4-way decomposition of the US 10-year yield reveals: Is inflation or rate hikes the main driver of US interest rates?

In the previous article, I introduced the fact that the factors driving US interest rate increases differ by maturity.

Specifically, the 2-year yield is driven by rate hike expectations.

The 30-year yield is rising primarily due to the term premium (supply and demand, etc.).

Since the 10-year yield is sandwiched between the 2-year and 30-year yields, both rate hike expectations and the term premium are factors driving its increase.

At this point, sharp readers might be thinking:

How do inflation, rate hike expectations, and the term premium relate to each other?

In the previous article, I divided US interest rates into two components: rate hike expectations and the term premium, but in fact, it is possible to decompose them further into four parts.

As a result, you will be able to see how inflation is affecting US interest rates, so please look forward to it.

■ How to decompose US interest rates into four parts

Now, let’s get straight to the point.

If we write the decomposition of US interest rates introduced in the previous article as a formula, it becomes:

US Interest Rate = Rate Hike Expectations + Term Premium

.

And these two can be decomposed as follows:

Rate Hike Expectations = Expected Inflation Rate + Real Rate Hike Expectations

Term Premium = Real Term Premium + Inflation Risk Premium

A formula has suddenly appeared, but I will explain it in an easy-to-understand way.

First, to give you an overall picture, I have created a diagram outlining the 4-way decomposition.

■ Decomposing rate hike expectations into two parts

First, regarding the decomposition of rate hike expectations. What we call “interest rates” is what is known as the “nominal interest rate.”

Nominal interest rates can be broken down into an “inflation component” and “everything else (real).”

Therefore, rate hike expectations can also be broken down into an “inflation component” and “everything else (real).”

Regarding this “inflation component,” we use inflation forecast values from experts.

As a result, we get the breakdown mentioned earlier.

Rate hike expectations = Expected inflation rate + Real rate hike expectations

(Note) If you use the BEI of inflation-indexed bonds as is, the value can sometimes be slightly distorted due to supply and demand factors of the inflation-indexed bonds, so we use inflation forecasts from experts instead.

■ Breaking down the term premium into two

Next, regarding the breakdown of the term premium.

The term premium is the “compensation for risk (uncertainty).”

In the previous article, I introduced that the term premium for the US 2-year yield is quite small.

A US 2-year Treasury bond reaches maturity if held for two years, and the uncertainty of the US policy rate during that time is not large (compared to the next 10 years, etc.).

Therefore, the 2-year yield has relatively low risk (uncertainty), so the term premium is also small.

On the other hand, regarding US 10-year and 30-year yields, since we are talking about the next 10 to 30 years, the uncertainty (= risk) of interest rates is naturally large, and the term premium is larger accordingly.

Now, interest rate risk (volatility) can also be divided into an inflation component and everything else (real).

Assuming interest rates fluctuate in the future, will they move due to inflation factors or due to other factors (supply and demand, growth rates, etc.)?

The breakdown of that is as follows.

Term premium = Real term premium + Inflation risk premium

Here, I will repost the 4-part breakdown chart from earlier.

■ Results of actually breaking down US interest rates into 4 parts

Now, here is the actual 4-way breakdown of the US 10-year yield.

■ Components of the US 10-year yield

In the current US 10-year yield, the inflation component (purple) is the largest.

Next are the real short-term interest rate (real-based rate hike expectations, blue), and the real term premium (orange), which make up the remaining components.

■ Factors driving the rise in the US 10-year yield: 2021–2023

So, what is the factor “pushing up” the US 10-year yield?

This shows the changes in the components of the US 10-year yield, with five years ago set as zero.

Looking at it this way, can you see how the power dynamics have shifted?

From 2021 to 2023, the factor that significantly pushed up the US 10-year yield was the real short-term interest rate; in other words, the aggressive rate hikes by the Fed were the cause of the rise in the US 10-year yield.

Regarding the inflation rate, it certainly rose to nearly 9% at one point, but long-term inflation expectations did not rise as much. This can be attributed to the prevailing view that inflation would be calmed by the Fed’s rate hikes.

■ Factors driving the rise in the US 10-year yield: 2025–Present

So, what is the cause of the recent rise in interest rates?
This shows the changes in the components of the US 10-year yield, with one year ago set as zero.

The factor pushing interest rates up the most is real rate hike expectations (blue). With the Fed shifting back toward rate hikes, the US 10-year yield has been pushed upward.

Also, with concerns about US fiscal policy smoldering, the real term premium (orange) has also risen.

Looking at everything so far, the recent rise in US interest rates is primarily due to Fed rate hikes and fiscal concerns.

Regarding inflation, the prevailing view is that it can be contained to some extent by the Fed’s interest rate hikes.

The background to the Fed’s rate hikes is inflation. In that sense, inflation can be said to be a factor in the rise of US interest rates.

However, the primary cause of the rise in interest rates is ultimately not inflation expectations, but rate hike expectations.

This means that the view that inflation can be contained to some extent through rate hikes is being reflected.

■ Can the risk of inflation be ignored?

However, it is concerning that inflation expectations (purple) are also rising, albeit slightly.

This may reflect the view that even if the Fed raises interest rates, inflation will become normalized at a higher level than before. Now, regarding this inflation risk, I will delve deeper into it in the next installment and beyond.

■ Summary

• As a result of breaking down the US 10-year yield into four components, the primary reason for the upward pressure on the US 10-year yield is rate hike expectations.

• In the sense that the background to rate hikes is inflation, it can be said that inflation is pushing up US interest rates, but since the rise in inflation expectations is limited, it can be said that the view that inflation will be contained as a result of rate hikes is dominant.

• Following rate hike expectations, the next factor pushing up the US 10-year yield is the real term premium. This reflects concerns such as fiscal issues.

• Although slight, the rise in inflation expectations is a point of concern. If inflation expectations remain high, it will become difficult for both the policy rate and the 10-year yield to fall