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The Bond Market’s Crystal Ball
In March 2009, the financial crisis was in full swing and Federal Reserve Chairmen Ben Bernanke went on 60 Minutes to try and calm the nation’s nerves.
At one point in the interview, Bernanke was asked, “You’ve been printing money?” and he responded, “Well, effectively.”
Bernanke’s comment, along with the Fed’s decisions to lower short term interest rates to near zero, keep them there and then purchase $2.1 trillion dollars in bonds through a process known as quantitative easing, has rightly caused the world to worry about rising prices.
And yet, two years after that 60 Minutes interview, inflation is still tame. Since that time, through the end of February, inflation, as measured by the Consumer Price Index (CPI), rose by 4.56 percent or 2.36 percent on an annualized basis, well below the long-term trend, which is close to three percent.
This data includes the volatile food and energy components, often referred to as ‘headline’ inflation. When these items are excluded, ‘core’ inflation is even lower – a total of 2.25 percent, or 1.17 percent annualized.
With gold and silver at record highs, oil trading above $100 per barrel, and the Federal Reserve still ‘printing money’ through a second round of quantitative easing, it’s hard not to think that inflation may be on the horizon.
Despite all of these factors, however, the bond market still expects relatively modest inflation over the next five years. Bond investors are particularly attuned to inflation because bonds generally have a fixed rate of interest and inflation will be the dominant factor in determining the ‘real’ or inflation adjusted return.
We know that the bond market is expecting modest inflation for the next few years by looking at the rates of regular, or ‘nominal,’ U.S. Treasury Bonds compared to the rate of Treasury Inflation Protected Securities (TIPs).
TIPs are unique because the principal is continually adjusted for inflation using the Consumer Price Index (CPI). As the principal adjusts, the interest payments change and protect the holder against rising inflation. Non-inflation adjusted returns are referred to as ‘nominal’ rates of return, while returns that are adjusted for inflation are known as ‘real’ returns.
By comparing the nominal yields on Treasury bonds with the real return on TIPs, we can assess the bond market’s assumption about inflation since, in theory, the nominal yield on Treasury bonds minus expected inflation should equal the real yield on TIPs.
Here’s how it works: The current five year Treasury bond has a nominal yield of 1.76 percent. The current five year TIP has a real yield of -0.58 percent. If we subtract the current real yield on the TIP from the nominal Treasury bond yield, we get the TIPs breakeven rate, which is 2.34 percent. (The math is a little complicated, since the real yield of the TIPs is negative you actually end up with a larger number.)
The breakeven rate of 2.34 percent suggests the rate of inflation where bond market investors will make the same rate of return regardless of which type of bond they buy.
If investors believe that inflation will be higher than 2.34 percent over the next five years, then they will favor the TIPs and if they believe that inflation will be lower than 2.34 percent over the next five years, then they would prefer the regular Treasury bond.
The most appropriate ETFs to execute a viewpoint on inflation are the iShares Barclays TIPs Bond fund (NYSEARCA:TIP) and the Vanguard Intermediate Term Government Bond fund (NASDAQ:VGIT).
According to Morningstar, the duration for TIP is 5.19 years, 5.29 years for VGIT, so the term is essentially identical. Both are very inexpensive – Morningstar reports that the expense ratio by prospectus is 0.20 percent for TIP and 0.15 percent for VGIT.
Although inflation expectations are higher today than in the years since 2008, the bond market isn’t signaling hyperinflation or anything out of the ordinary. That can change of course, but for now, market expectations call for higher, though still muted, inflation.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Disclaimer: The views expressed do not necessarily represent the views of Acropolis Investment Management, LLC. or its members. Clients of Acropolis own TIP as a core holding and we are regularly buying and selling TIP for clients as part of our portfolio rebalancing strategy.