Have we ever talked about the "Breakeven Inflation Rate" ? We probably should .....

Thursday 12th November 2015

Have we ever talked about the "Breakeven Inflation Rate" ? We probably should .....

Ref : "Goldman to Bond Traders : You're Underestimating U.S. Inflation" , Bloomberg Markets

          & bondeconomics.com

In essence, the above article highlights the view of Goldman Sachs that alongside slowing global growth it's the slump in energy prices that has weighed down inflation forecasts. But in the US at least, growth remains steady and since Consumer Price Index data is calculated on a year-on-year basis, as time marches on the low oil price will exert an increasingly weaker influence on headline inflation numbers  --  all of which means that they believe current inflation forecasts to be way too low. Their prediction ? The 10yr breakeven rate, currently at 1.58% and already on the rise from a six year low set in September, will rise to 2%.

That's all well and good (and perfectly logical, incidentally), but may not mean a lot to those who aren't sure what the breakeven rate is. So, for newcomers and at its most basic, here goes :

The Breakeven Inflation Rate is a market-based measure of expected inflation, and is the difference between the yield of a nominal bond and an inflation-linked bond of the same maturity and quality.

So, with regard to the current level of 1.58 in the case of US Treasury Bonds referred to above :

(%)Yield on 10yr US Treasury Note :                                                          2.33

(%)Yield on 10yr Treasury Inflation Protected Securities (or TIPS) :              0.75  -

                                                         10yr Breakeven Inflation Rate :          1.58 bp

* Note that since protection from inflation has a value, the yield on TIPS (or any other index-linked bond) would generally be lower than its regular (or nominal) equivalent.

** The yield on TIPS is often referred to as the "real yield", but beware : that can mean different things in different circumstances.

What that simple sum above is actually saying is that IF inflation was to stay at exactly 1.58% for 10 years, there would be no difference in the returns provided by the two different assets, normal bonds and TIPS.

If inflation was to exceed 1.58%, you would be better off owning TIPS : and conversely, if inflation was to fall below 1.58%, you'd want to be in normal Treasuries.

In the belief that inflation is going to be higher than 1.58% (and move out to 2%), Goldman are suggesting that you instigate a spread trade that BUYS the TIPS, and SELLS the normal Treasuries.

Remember that yields move inversely to prices, so if the spread widens that means that the YIELD on the TIPS is comparatively even lower than that of the normal bond, therefore its PRICE is comparatively higher ..... which means PROFITS !

So there you have it ...... Breakeven Inflation Rates are important for many reasons, not least because they allow us to compare the market's inflation projections with those provided by economists and surveys. It's remarkable how far apart they can be. Which is not to say that the market's right necessarily ..... it's just nice to know what they're talking about.