Inflation Breakeven Rate: What It Really Tells You About TIPS

Summary

• Inflation breakeven rates have been rising fairly steadily since February 2016 and now are in the 'neutral' zone of value.
• When inflation breakevens rise, TIPS outperform nominal Treasurys.
• The lower the breakeven rate, the higher the 'margin of safety' for TIPS investors versus nominal Treasurys.

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. But there's a lot of confusion about what this measure means and how an investor should interpret it.

First of all, what is it? The inflation breakeven rate results from a simple calculation: Nominal yield minus real yield. 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. Right now, that calculation looks like this:

2.86% (nominal yield) - 0.74% (real yield) = 2.12%

This tells you that investors are 'expecting' inflation to average 2.12% over the next 10 years. It is a market-based calculation. Think inflation will be higher than 2.12%? Buy TIPS. Think inflation will be lower than 2.12%? Buy a nominal Treasury.

Does it accurately predict future inflation? Not necessarily. The inflation breakeven rate is not a forecast; it is a snapshot of today's inflation expectations. As it turns out, what investors expect often turns out to be wrong. I discussed this in detail in a July article: "Does TIPS' Inflation Break-Even Rate Accurately Predict Future Inflation?" Here's what I found:

(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. The more recent trend - because of several years of super low inflation - has been to overestimate inflation.

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%. Investors were either wrong in July, or they are wrong today. The inflation breakeven rate is a measure of sentiment. It should not be considered an accurate forecast.

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. When the inflation breakeven rate drops to very low levels, as it did in recent years, TIPS are 'cheap' versus nominal Treasurys. When it rises to high levels, TIPS are 'expensive' versus nominal Treasurys.

Historically, when the 10-year TIPS breakeven falls below 2.0%, TIPS are cheap. When it rises above 2.5%, TIPS are expensive. The range from 2.0% to 2.5% is 'neutral,' neither cheap nor expensive. However, recent years of very low inflation may have thrown this general rule out of whack.

The trend movement of the inflation breakeven rate is directly related to the price trend of TIPS versus nominal Treasurys. 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). I chose these two funds because they have very similar durations, making them equally sensitive to interest rate changes.

Falling inflation expectations

First, let's look at two periods of falling inflation expectations. The first is from April to September 2011, when then 10-year inflation breakeven rate fell dramatically from 2.63% to 1.74%. Here is the trend:

And here is the relative performance of the TIP ETF versus IEF over that same period:

In this period of falling inflation expectations, nominal Treasurys greatly outperformed TIPS, even though both asset classes increased in value. Yields for both were falling, but the TIPS yield decline was much smaller (81 basis points versus 135). So TIPS underperformed as the inflation breakeven rate dropped.

Here's another period of declining 10-year breakeven rates, July 2014 to February 2016:

And here is the relative performance of TIP versus IEF for that period:

In this period, IEF gained value as the nominal 10-year Treasury yield dropped 95 basis points. At the same time, the 10-year TIPS real yield rose 10 basis points. The result: nominal Treasurys gained value; TIPS lost value.

Rising inflation expectations

Now, let's take a look at two periods of rising inflation expectations. The first is from October 2010 to April 2011. Here is the breakeven trend:

And here is the resulting performance of the two ETFs:

In this case, the value of both Treasury ETFs declined during a period of rising inflation expectations, but the decline in Treasury Inflation-Protected Securities was negligible versus a 7% drop in value of nominal intermediate Treasurys. When the breakeven rate has fallen to a 'cheap' level - as it was on October 4, 2010, at 1.78% - investors have a 'margin of safety' versus nominal Treasurys.

Finally, let's take a look at our current investing environment, because we are in a period of rising inflation expectations. That means that TIPS should be outperforming nominal Treasurys as long as this trend continues. Here is the current trend, dating back to February 2016:

And here is the resulting performance of TIP versus IEF:

Again, rising inflation expectations don't mean that TIPS are exploding higher - not in a period of rising nominal yields. But TIPS are outperforming nominal Treasurys and will continue that trend as long as the breakeven rate is rising.

What this means for investors

Back in January 2015, I wrote an article, 'TIPS Investors: Why The Inflation Breakeven Rate Is Your Friend,' that made the case for investing in TIPS versus nominal Treasurys. At the time, the 10-year inflation breakeven rate was 1.57% - extremely low by historical standards. I predicted:

When the inflation breakeven trend reverses to 'more normal' levels, TIPS are going to outperform traditional Treasuries and probably the overall bond market.

Today, the 10-year breakeven rate stands at 2.12%, which is 'neutral' on the historical scale.

TIPS mutual funds are not a 'screaming' buy today versus nominal Treasurys. They seem fairly priced. If the inflation breakeven rate continues to rise - rates of 2.6% are not unheard of - then TIPS will outperform Treasurys. If the breakeven rate falls - TIPS will underperform.

Remember: The breakeven rate does not forecast future inflation. It is a measure of today's sentiment. And it is a very accurate measurement of the relative 'value' of TIPS versus nominal Treasurys.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Comments

[acirvin]

Thanks for the article and comments, sorry I'm late to the party! The thing I want to know is can't the Fed just manipulate these numbers by the amount of tips/treasuries it buys? And if so, how is the breakeven rate a reliable indicator?

[Tipswatch]

@acirvin The Fed can (and has been) manipulating real and nominal yields, but investors generally set the breakeven rate by opting to buy a nominal Treasury or a TIPS. In the last two years, however, the Fed has been buying enough TIPS to skew that equation. The breakeven rate is just a measure of market sentiment, it is not an accurate predictor of future inflation.

[acirvin]

@Tipswatch Thank you so much for the reply! I imagine two jars connected by a tube. The Fed can add or remove water from either or both jars, but (unless there were no private buyers or sellers at all), the relative levels of water in the two jars would tend toward some market-based equilibrium reflective of future CPI expectations? Also, if The Fed wanted the manipulate the breakeven rate lower to underrepresent inflation expectations, you would think it would SELL TIPS and/or buy treasuries.

[BondGuy]

2008 was the buying opportunity of a lifetime for TIPS. One could have bought totally safe assets with a 4% guaranteed real return, which was within shooting distance of the equity return premium with zero risk. Of course, I foolishly did not, because I didn't understand that then. (The "Saddest words, it might have been.") I do now, and would go all in if we ever had another TIPS crash. Also of note, much of the "crash" was Lehmann dumping its TIPS into an illiquid market, a less likely scenario today.

[Listening for safety/sanity]

Can you comment about potential risk of TIPS in the context of recent correction (and coming -sometime-) next bear market wherein in recent correction, both gold and nominal treasuries sold off along with equities. Do TIPS have that same risk of unexpected correlation with equity value (which has not previously been the case) in the next bear market with the expectation that it will be the “everything crisis”, including especially over leveraged large pension funds and equities with an uncharacteristically large amount of current value based on their past decade of corporate “investing” in buybacks rather than long term true organic growth? Thank you.

[Tipswatch]

In the big crash of 2008, the TIP ETF sold off 14.25% from March to November, while IEF increased 4.8% and BND (total bond market) was down only 2.65%. The stock market (SPY) was down 39.4%. That doesn't bode well for TIPS in the early days of a major bear market, because the fear of deflation sends investors running to nominal yields. But once quantitative easing began, TIPS had a major rally, because investors (wrongly) that QE would be inflationary.

[Brasada]

"The breakeven rate does not forecast future inflation. It is a measure of today's sentiment. And it is a very accurate measurement of the relative 'value' of TIPS versus nominal Treasurys."

Isn't this in fact a market prediction of future inflation just was the SPY is a prediction of the future economy (but changes on a daily basis)?

Hasn't the "value" increased since 2017 due to market perception that inflation expectations has increased since that time?

[Tipswatch]

Yes, the inflation breakeven rate is a one-day snapshot of expected future inflation. The stock market is also a snapshot of expected future earnings, but those decisions are spread across 1,000s of stocks, or in the case of SPY, 500 stocks weighted by market cap.

[BondGuy]

I would also measure "cheapness" by whether the implied breakeven inflation is above or below the Fed's target. US TIPS have been cheap by that measure until quite recently, as the implied breakeven has been below the Fed's 2% target. It now appears that the breakeven is above the Fed target at some maturities, making them relatively dear. However, that may simply reflect the market view that Fed will allow inflation to run above its official target as a sort of catch up, meaning TIPS are still a good value. All that said, evaluating whether you should buy TIPS in this manner can lead one to miss their most important characteristic -- insurance against high, unexpected inflation. It hardly matters over time if nominal bonds beat TIPS by a few basis points every year. You can lose with TIPS, but when you do, you are likely to lose by very little. When you lose with nominal bonds, you risk losing by a lot -- potentially catastrophically. TIPS are insurance -- fairly cheap insurance -- against an inflation catastrophe. I think breakeven rates matter significantly only to an entirely different class of investors, hedge funds and leveraged long/short traders to whom marginal basis points are leveraged to make a big difference in returns. It has virtually no relevance to small investors like myself, except to know in the abstract that such a concept exists.

[Tipswatch]

I always appreciate your feedback, BondGuy. I get a lot of questions about the breakeven rate, and what it means. So this was an attempt to clarify that: 1) it does not accurately predict future inflation, and 2) it does accurately represent the 'value' of TIPS versus nominal Treasurys. It's probably worth watching the breakeven rate if you invest heavily in TIPS mutual funds (I don't). When the breakeven rate gets very high, it's probably wise to add investments in nominal bonds.

TIPS will perform best when inflation runs higher than expected. That's not something we wish for, but TIPS are the insurance against that possibility. And like you said, that insurance isn't very expensive when nominal rates are so low anyway.

[Hockeypuck*]

Really good article. Unfortunately, I came to same conclusion. TIP does seem to perform gangbusters in rising inflation expectation environment. Have not thought that through totally. Is there contango on TIP?