Extracting Inflation Expectations from Treasury and TIPS Yield Curves<\/strong><\/p>\n

Update (08\/22\/2012): I have posted a similar but simplified method for calculating the breakeven rate here<\/a>.<\/em><\/p>\n

What level of inflation do market participants expect over the next 5, 10, or even 30 years?\u00a0\u00a0 There are many methods of varying complexity that investors and policymakers use to estimate the level of expected inflation, but one relatively straightforward method is to examine the \u201cbreakeven\u201d inflation rate<\/a> which is the difference in\u00a0interest rates\u00a0between Treasuries and TIPS.\u00a0 This method has the advantage of being determined by market prices, so it reflects the views of investors who have money on the line.<\/p>\n

A simple example illustrating the 5-year breakeven inflation rate is shown here:<\/p>\n

<\/a><\/p>\n

The 5-year breakeven inflation rate is the difference between the 5-Year Treasury Constant Maturity Rate (in this case the most recent rate is 1.95%) and the yield on an inflation protected security with 5-years remaining to maturity (in this case -0.04%).\u00a0 Therefore, the plot implies investors expect inflation of approximately 2% annually over the next 5 years.\u00a0 It can also be seen from the graph that the breakeven inflation rate, while not particularly high, has been rising over recent months as the gap between the two series has widened.<\/p>\n

Notice that this plot shows a 10-year off-the-run\u00a0inflation indexed security\u00a0with 5-years to maturity.\u00a0 The purpose of using the off-the-run security, rather than the a 5-year on-the-run bond, \u00a0is to reduce the\u00a0distortion in rates caused by\u00a0the deflation protection aspect of TIPS<\/a>, although that effect is less of a concern today than it was\u00a0during the crisis\u00a0of 2008.<\/p>\n

Why should we expect that the difference in yields is equal to the market’s expectation for inflation?\u00a0 If investors expected future inflation to be greater than this difference, then this would make TIPS, whose coupon and principal payments are indexed to the CPI,\u00a0more attractive\u00a0to investors than\u00a0nominal Treasuries and the\u00a0difference would increase as investors sold Treasuries (pushing down\u00a0the price down and yield up)\u00a0to buy TIPS (pushing the price up and yield down).\u00a0 If inflation expectations were lower than this difference, then Treasuries would be more attractive\u00a0to investors than\u00a0TIPs and the opposite effect would occur.\u00a0 Therefore, in equilibrium, the difference should roughly reflect\u00a0the market’s consensus for future inflation.<\/p>\n

If we want to see inflation expectations over a longer term, we can use the Treasury and TIPS yield curve rates which are published daily on the U.S. Treasury Department website<\/a>.\u00a0 I’ve created an Octave script<\/a> to generate plots of inflation expectations\u00a0using the Treasury data.\u00a0 The next\u00a0plot uses the rates from the Treasury website, and a spline interpolation method to generate the Nominal and Real Treasury Yield curves.\u00a0 The difference here can be interpreted as the rough annual inflation expectation\u00a0over a horizon equal to the time to maturity.<\/p>\n

<\/a><\/p>\n

A problem with the two graphs I have shown is that the bond yields reported at each maturity are the rates for \u201ccoupon\u201d bonds.\u00a0 This means that\u00a0a coupon payment\u00a0is paid out to investors at each 6-month interval, so the yield is really a weighted average interest rate for the various cash flows investors receive at dates up to and including the final principal payment.\u00a0 In order to get a pure measure of the interest rates\u00a0at each\u00a0maturity we must remove the effects of the coupon payments.<\/p>\n

The next graph shows the \u201czero coupon\u201d interest rates at each horizon.\u00a0 These curves were derived from the\u00a0coupon curves using a \u201cbootstrap\u201d methodology.\u00a0 These curves show a cleaner measure of interest rates and the breakeven inflation rate at each horizon.<\/p>\n

<\/a><\/p>\n

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Notice that the breakeven inflation in this graph is somewhat higher now that interest rates have been adjusted to show the zero coupon rates, but it is still below 3% at\u00a0all horizons.<\/p>\n

Finally, it is possible to process this data further\u00a0and compute the\u00a0forward interest rates and \u00a0inflation expectation at each point in the future.\u00a0 However, we don\u2019t really have enough data to do this properly, and the shape of the graph is very dependent on the interpolation method used to fill in the missing maturities.\u00a0 Be sure to take this next\u00a0graph with a grain of salt!\u00a0 In particular, I believe the dip and steep upswing in rates at the long horizons is an effect of the interpolation method.<\/p>\n

<\/a><\/p>\n

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Problems with using the breakeven inflation rate<\/strong><\/p>\n

There are several reasons why the breakeven inflation rate is not a perfect estimate of inflation expectations.<\/p>\n

First, investors in Treasuries bear the risk that inflation may be very different from the level expected by the market, but investors in TIPS, which are adjusted for whatever inflation occurs,\u00a0do not bear this risk.\u00a0 So, the Treasury yield may include an extra risk premium to compensate for this additional risk.<\/p>\n

A second distortion is that the Treasury market is more heavily traded and liquid than the TIPS market.\u00a0 As a result, the yields on TIPS may have an additional premium to compensate for lower liquidity.\u00a0 This may partly explain why the 5-yr breakeven inflation rate, shown in the first graph,\u00a0went negative in 2008.\u00a0 Some investors believe that this signaled expected deflation, but others believe that a rush to liquidity caused the liquidity premium to increase which pushed up the yields on TIPS.<\/p>\n

Finally,\u00a0some investors believe that the CPI, which is used to adjust the principal and coupon payments on TIPS, is not an accurate measure of the true level of\u00a0inflation.\u00a0 That discussion is outside the scope of this post, but it is true that the inflation expectation measured by the breakeven rate is inflation as measured by the CPI.<\/p>\n

Final Thoughts<\/strong><\/p>\n

Inflation has the potential to greatly affect our investment outcomes.\u00a0 I think it will be interesting to keep an eye on inflation expectations over the coming years since they are an important input for Federal Reserve decision making, and they are a measure of the market\u2019s confidence in the Fed\u2019s ability to do its job.\u00a0 However, I don\u2019t think that estimating the level of inflation expectations will provide any actionable insight which will help you to improve your investment performance.\u00a0 In constructing an investment portfolio, you should consider and plan for the possibility<\/em> of inflation regardless of the level of future inflation expected by the market.<\/p>\n","protected":false},"excerpt":{"rendered":"

Extracting Inflation Expectations from Treasury and TIPS Yield Curves Update (08\/22\/2012): I have posted a similar but simplified method for calculating the breakeven rate here. What level of inflation do market participants expect over the next 5, 10, or even 30 years?\u00a0\u00a0 There are many methods of varying complexity that investors and policymakers use to […]<\/a><\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":[],"categories":[1],"tags":[],"_links":{"self":[{"href":"http:\/\/www.calculatinginvestor.com\/wp-json\/wp\/v2\/posts\/1091"}],"collection":[{"href":"http:\/\/www.calculatinginvestor.com\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"http:\/\/www.calculatinginvestor.com\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"http:\/\/www.calculatinginvestor.com\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"http:\/\/www.calculatinginvestor.com\/wp-json\/wp\/v2\/comments?post=1091"}],"version-history":[{"count":139,"href":"http:\/\/www.calculatinginvestor.com\/wp-json\/wp\/v2\/posts\/1091\/revisions"}],"predecessor-version":[{"id":1249,"href":"http:\/\/www.calculatinginvestor.com\/wp-json\/wp\/v2\/posts\/1091\/revisions\/1249"}],"wp:attachment":[{"href":"http:\/\/www.calculatinginvestor.com\/wp-json\/wp\/v2\/media?parent=1091"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"http:\/\/www.calculatinginvestor.com\/wp-json\/wp\/v2\/categories?post=1091"},{"taxonomy":"post_tag","embeddable":true,"href":"http:\/\/www.calculatinginvestor.com\/wp-json\/wp\/v2\/tags?post=1091"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}