Breakeven inflation rate

What Is Breakeven Inflation Rate?

The breakeven inflation rate represents the market's expectation of the average annual inflation rate over a specific period. It is a key metric within investment analysis, particularly in the fixed income market, derived from the difference in bond yields between a nominal Treasury security and a Treasury Inflation-Protected Security (TIPS) of the same maturity. This rate essentially indicates the level of inflation at which the total return of a nominal bond would be equal to that of a TIPS over its lifespan⁵⁸, ⁵⁹, ⁶⁰. Investors and analysts closely monitor the breakeven inflation rate to gauge market sentiment regarding future price changes and to inform their investment strategy.

History and Origin

The concept of inflation-indexed bonds, which are crucial for calculating the breakeven inflation rate, originated in the United Kingdom in 1981. Other countries followed suit, and in the United States, Treasury Inflation-Protected Securities (TIPS) were first auctioned in January 1997⁵⁶, ⁵⁷. The introduction of TIPS by the U.S. Treasury provided a direct market mechanism to observe inflation expectations. The primary purpose of issuing TIPS was initially to reduce the U.S. Treasury's long-term financing costs and to offer investors a way to protect their purchasing power against inflation⁵⁴, ⁵⁵. The difference in yields between these newly introduced inflation-indexed securities and conventional Treasury bonds quickly became a widely recognized, market-based measure of anticipated inflation, known as the breakeven inflation rate⁵², ⁵³.

Key Takeaways

• The breakeven inflation rate is a market-derived indicator of expected future inflation.
• It is calculated by subtracting the real yield of a TIPS from the nominal yield of a comparable conventional Treasury bond⁵⁰, ⁵¹.
• A higher breakeven inflation rate suggests that the market anticipates higher future inflation, while a lower rate indicates expectations of lower inflation⁴⁹.
• It is widely used by investors, policymakers, and central banks to understand inflation outlooks and guide decisions⁴⁷, ⁴⁸.
• The breakeven inflation rate is influenced by various factors beyond pure inflation expectations, including liquidity premiums and inflation risk premiums⁴⁵, ⁴⁶.

Formula and Calculation

The breakeven inflation rate is calculated as the difference between the nominal yield of a standard Treasury security and the real yield of a TIPS of the same maturity.

The formula is expressed as:

Where:

• Nominal Yield: The yield on a conventional Treasury bond that does not adjust for inflation⁴³, ⁴⁴.
• Real Yield: The yield on a Treasury Inflation-Protected Security (TIPS), which is adjusted for inflation⁴¹, ⁴².

For instance, if a 10-year nominal Treasury bond yields 4.5% and a 10-year TIPS yields 2.0%, the breakeven inflation rate would be 2.5% (4.5% - 2.0% = 2.5%)⁴⁰.

Interpreting the Breakeven Inflation Rate

Interpreting the breakeven inflation rate involves understanding what this market-implied figure suggests about future price levels. When the breakeven inflation rate rises, it indicates that investors expect higher average inflation over the bond's maturity period. Conversely, a falling breakeven inflation rate suggests that market expectations for future inflation are declining³⁹.

For example, a 5-year breakeven inflation rate of 2.5% implies that investors anticipate average inflation of 2.5% per year over the next five years. This information can guide investment decisions, particularly regarding asset allocation between nominal fixed-income assets and inflation-protected securities. If an investor believes actual inflation will be higher than the breakeven rate, they might prefer TIPS; if they believe it will be lower, a nominal bond might be more attractive³⁷, ³⁸. The Federal Reserve Bank of St. Louis, through its FRED database, provides widely followed 5-year and 10-year breakeven inflation rates, which are key indicators of these market expectations³⁶.

Hypothetical Example

Consider an investor, Sarah, who is deciding between two hypothetical 5-year government bonds:

1. Bond A (Nominal Treasury Bond): Pays a fixed annual interest rate (nominal yield) of 3.0%.
2. Bond B (Treasury Inflation-Protected Security - TIPS): Pays a real annual interest rate (real yield) of 0.5%.

To calculate the breakeven inflation rate for these bonds, Sarah subtracts the real yield of Bond B from the nominal yield of Bond A:

Breakeven Inflation Rate = Nominal Yield (Bond A) - Real Yield (Bond B)
Breakeven Inflation Rate = 3.0% - 0.5% = 2.5%

This means that if the average annual inflation rate over the next five years is exactly 2.5%, both Bond A and Bond B would provide Sarah with the same inflation-adjusted return.

• If actual inflation averages more than 2.5% over the five years, the TIPS (Bond B) would likely outperform the nominal bond (Bond A), as its principal and interest payments would increase with inflation, preserving Sarah's purchasing power.
• If actual inflation averages less than 2.5%, the nominal bond (Bond A) would likely offer a better real return than the TIPS.

This calculation helps Sarah make an informed decision based on her own outlook on future inflation.

Practical Applications

The breakeven inflation rate serves several practical applications for various market participants:

• Investment Decision-Making: Investors use the breakeven inflation rate to determine whether Treasury Inflation-Protected Securities (TIPS) or conventional Treasury bonds are more attractive given their outlook on future inflation. If an investor's personal inflation expectation exceeds the breakeven rate, TIPS may be preferred for their inflation protection. Conversely, if expected inflation is below the breakeven rate, nominal bonds might offer a better relative value³⁵. This helps investors refine their asset class allocation.
• Economic Forecasting: Economists and analysts consider the breakeven inflation rate a reliable, market-based indicator of market expectations for future inflation³³, ³⁴. It provides insights into how the market prices inflation risk, complementing other inflation measures like the Consumer Price Index (CPI)³².
• Monetary Policy Guidance: Central banks closely monitor the breakeven inflation rate as it offers a real-time gauge of inflation expectations held by market participants. This information is vital for formulating and adjusting monetary policy, helping them assess the credibility of their inflation targets and the potential need for intervention to maintain price stability³⁰, ³¹. The Federal Reserve, for instance, frequently references TIPS breakeven rates in discussions about inflation expectations²⁹.
• Risk Management: Financial institutions and corporations use the breakeven inflation rate to assess and manage inflation risk within their portfolios and liabilities. It helps in hedging strategies and in pricing financial products that are sensitive to changes in inflation.

Limitations and Criticisms

While the breakeven inflation rate is a widely used and valuable metric, it has certain limitations and faces criticisms that warrant a balanced understanding:

• Not a Pure Inflation Forecast: The breakeven inflation rate is often interpreted solely as the market's forecast for future inflation. However, it also includes an inflation risk premium and a liquidity premium²⁷, ²⁸. The inflation risk premium compensates investors for the uncertainty surrounding future inflation, while the liquidity premium reflects the fact that Treasury Inflation-Protected Securities (TIPS) markets may be less liquid than conventional Treasury bonds markets²⁴, ²⁵, ²⁶. These premiums can cause the breakeven rate to deviate from true inflation expectations. For example, a decrease in the liquidity of TIPS could depress their real yield, thereby increasing the breakeven inflation rate, even if inflation expectations haven't changed²², ²³.
• Short-Term Volatility: The breakeven inflation rate can be influenced by various short-term factors and market distortions, leading to volatility that may not reflect long-term inflation trends accurately²¹. For shorter maturities, the breakeven rate might be less reliable as a proxy for economic expectations due to these factors²⁰.
• Indexation Lag and Seasonality: Technical factors related to the construction of inflation-indexed securities, such as indexation lag (the delay between changes in the consumer price index and the adjustment of the bond's principal) and seasonality in inflation data, can introduce distortions into the breakeven inflation rate¹⁹.
• Correlation Puzzles: Research has noted "puzzling correlation relationships" where the real bond yields and breakeven inflation rates can sometimes be negatively correlated due to market-related price distortions, especially during periods of market turbulence¹⁸.

Despite these limitations, the breakeven inflation rate remains an important tool for financial professionals and policymakers, providing valuable insights into market-implied inflation expectations when interpreted with an understanding of its underlying components.

Breakeven Inflation Rate vs. Real Interest Rate

The breakeven inflation rate and the real interest rate are distinct concepts in finance, though both are crucial for understanding the impact of inflation on returns.

The breakeven inflation rate is a market-derived expectation of future inflation. It is the specific inflation rate at which the returns of a nominal bond and a Treasury Inflation-Protected Security (TIPS) of the same maturity would be equal¹⁶, ¹⁷. It reflects the difference between the nominal yield (what you see advertised on a bond, unadjusted for inflation) and the real yield (the yield on a TIPS, adjusted for inflation)¹⁵.

In contrast, the real interest rate refers to the return on an investment or the cost of borrowing after accounting for inflation¹⁴. It measures the true increase in purchasing power¹², ¹³. A nominal interest rate is the stated rate, while the real interest rate is calculated by subtracting the inflation rate (actual or expected) from the nominal interest rate¹¹. The Fisher Equation formalizes this relationship: Real Rate ≈ Nominal Rate - Inflation Rate.
¹⁰
The key distinction is that the breakeven inflation rate is an implied expectation derived from the market's pricing of two different types of bonds, serving as a forecast of future inflation. The real interest rate, on the other hand, describes the actual return or cost after inflation has occurred or after a specific inflation rate has been accounted for.

FAQs

What does a high breakeven inflation rate signify?

A high breakeven inflation rate indicates that investors in the bond market expect a higher average rate of inflation over the life of the bond. It suggests that participants are demanding greater compensation for inflation risk.
⁹

How does the breakeven inflation rate relate to the Consumer Price Index (CPI)?

The breakeven inflation rate is often viewed as a market-based forecast for future CPI, which is a common measure of actual inflation. ⁷, ⁸However, the breakeven rate is an expectation derived from market prices, while CPI measures past price changes.

Can the breakeven inflation rate be negative?

While rare, a negative breakeven inflation rate could occur if the yield on Treasury Inflation-Protected Securities (TIPS) is higher than that of comparable nominal Treasury bonds. This would imply market expectations of deflation, where prices are anticipated to fall.
⁶

Why do central banks monitor the breakeven inflation rate?

Central banks monitor the breakeven inflation rate because it provides insights into market expectations for inflation, which is a critical input for calibrating monetary policy. It helps them assess whether their policies are effectively anchoring inflation expectations around their targets.
⁴, ⁵

Is the breakeven inflation rate a perfect predictor of future inflation?

No, the breakeven inflation rate is not a perfect predictor. While it is a strong market-based indicator of expectations, it includes factors beyond pure inflation forecasts, such as liquidity premiums and inflation risk premiums. ², ³Actual inflation may turn out to be higher or lower than the breakeven rate.¹