The first is from April to September 2011, when then 10-year inflation breakeven rate fell dramatically from 2.63% to 1.74%. Falling inflation expectationsįirst, let's look at two periods of falling inflation expectations. I chose these two funds because they have very similar durations, making them equally sensitive to interest rate changes. To show this correlation, I analyzed how periods of rising and falling 10-year breakevens affected the asset value of two ETF funds: the iShares TIPS Bond ETF ( TIP) (which holds all maturities of TIPS) and the iShares 7-10 Year Treasury Bond ETF ( IEF) (which holds 7- to 10-year Treasuries). The trend movement of the inflation breakeven rate is directly related to the price trend of TIPS versus nominal Treasurys. However, recent years of very low inflation may have thrown this general rule out of whack. The range from 2.0% to 2.5% is 'neutral,' neither cheap nor expensive. When it rises above 2.5%, TIPS are expensive. Historically, when the 10-year TIPS breakeven falls below 2.0%, TIPS are cheap. When it rises to high levels, TIPS are 'expensive' versus nominal Treasurys. When the inflation breakeven rate drops to very low levels, as it did in recent years, TIPS are 'cheap' versus nominal Treasurys. So what can the breakeven rate tell us? The inflation breakeven rate is a very accurate measure of the relative value of TIPS versus nominal Treasurys, and a possible predictor of the relative future performance of the two asset classes. It should not be considered an accurate forecast. The inflation breakeven rate is a measure of sentiment. Investors were either wrong in July, or they are wrong today. When I wrote that July article, the 10-year inflation breakeven rate stood at 1.73% and today it is 39 basis points higher at 2.12%. The more recent trend - because of several years of super low inflation - has been to overestimate inflation. (I)n the 11 years of TIPS auctions with completed 10-year maturities, inflation was underestimated in seven of those years, and overestimated in four of those years. I discussed this in detail in a July article: " Does TIPS' Inflation Break-Even Rate Accurately Predict Future Inflation?" Here's what I found: As it turns out, what investors expect often turns out to be wrong. The inflation breakeven rate is not a forecast it is a snapshot of today's inflation expectations. Think inflation will be lower than 2.12%? Buy a nominal Treasury.ĭoes it accurately predict future inflation? Not necessarily. Think inflation will be higher than 2.12%? Buy TIPS. This tells you that investors are 'expecting' inflation to average 2.12% over the next 10 years. Right now, that calculation looks like this:Ģ.86% (nominal yield) - 0.74% (real yield) = 2.12% For example, the 10-year inflation breakeven rate is calculated by subtracting the real (after inflation) yield of a 10-year TIPS from the nominal yield of a traditional 10-year Treasury. But there's a lot of confusion about what this measure means and how an investor should interpret it.įirst of all, what is it? The inflation breakeven rate results from a simple calculation: Nominal yield minus real yield. When I write about auctions of Treasury Inflation-Protected Securities, I always reference the new issue's 'inflation breakeven rate,' the key measure of 'expected' future inflation.
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