U.S. Breakeven Inflation
I recently reviewed a breakeven inflation chart and noticed some interesting trends. In this article, I will explain the implications of TIPS pricing for non-finance individuals.
Breakeven inflation rate
The breakeven inflation rate is a measure that indicates the inflation rate at which an inflation-linked bond, such as TIPS in the U.S., would have the same total return as a conventional bond. It reflects what the market expects for inflation. It’s important to note that breakeven inflation rates are not solely driven by short-term trading perspectives but also play a role in long-term valuation compared to realized inflation.
Looking at the chart, the top panel represents the 10-year breakeven inflation rate. While it rose slightly after the pandemic, it is currently lower than pre-Financial Crisis levels and similar to the immediate post-crisis period. This is due to persistent inflation target misses, which led to a decrease in breakevens during the 2010s. Surprisingly, despite the ongoing discussions about inflation, there is not much inflation risk premium factored into pricing.
The bottom panel displays the forward breakeven inflation, which is the 5-year rate starting 5 years in the future. This rate is even lower than its usual pre-2014 level and remained relatively stable after recovering from the post-recession dip. One possible explanation is that inflation bulls focused more on short-dated breakevens, while inflation bears paid attention to long-dated breakevens, resulting in a mechanically depressed forward rate.
While I cannot provide investment advice, I can offer some observations. Given the minimal presence of an inflation risk premium, TIPS appear to be a relatively affordable option for hedging against inflation. However, it’s worth noting that they may not be considered cheap.
Surprisingly, breakeven volatility has been less dramatic than expected, considering recent movements in inflation. The undershoot during the recession was somewhat anticipated due to negative oil prices and expectations of a prolonged economic downturn. However, the response to the inflation spike was relatively subdued.
Based on market pricing, it seems that either inflation is expected to revert on its own, or the Federal Reserve is anticipated to take substantial measures if inflation doesn’t revert. This suggests that the market is banking on inflation coming under control.
Disclaimer:
Please note that this article is intended to provide insights and not investment advice.
