![]() ![]() Traditional bonds are priced around the objective of getting a return that exceeds expected inflation. Such trading would continue until the market reaches the equilibrium we observe. If enough traders thought inflation would be higher than this, they would buy TIPS and sell treasuries, raising the price of TIPS today, and giving us lower TIPS yields, higher treasury yields, and a larger break-even inflation rate. But if inflation falls short, TIPS will underperform. If realized annual inflation exceeds 2 percent over the next thirty years, then TIPS will outperform treasuries. Over the next thirty years, the markets have priced in expectations for inflation of about 2 percent. Without a liquidity or inflation-protection premium, this represents the market’s equilibrium estimate of future inflation. The difference between these yields is the implied break-even inflation rate: 1.97 percent, or approximately 2 percent. Its nominal yield is unknown, as it also depends on realized future inflation. Meanwhile, a thirty-year TIPS offers a real yield of 0.95 percent. ![]() Its real yield is unknown and depends on realized future inflation. Exhibit 1.2: US Government Yield Curve and Implied Break-Even Inflation, May 1, 2019Īgain, we see with the thirty-year maturity that treasuries yield a nominal 2.92 percent. ![]() Exhibit 1.2 uses the same data as in Exhibit 1.1 to find this difference. TIPS yields may not reflect the true underlying real interest rate because they have a few other components built into their pricing, such as a premium for their relative illiquidity as they represent a smaller market than treasuries, and a potential additional premium for the protection they provide against unexpected high inflation.ĭespite the other factors of TIPS pricing, the difference between Treasury and TIPS rates for the same maturity represents a reasonable market estimate of future inflation expectations. TIPS offer a break-even inflation rate, defined as the difference in yields on the same maturity of traditional treasuries and TIPS. With TIPS, we now have a better idea of market expectations for future inflation, though I would not call it perfect. With this risk premium added to the expectations theory, the typical or neutral shape for the yield curve becomes upward sloping. Longer-term bonds are less liquid, as well, since this price risk could force them to be sold at a loss if an unexpected expense arose. The other theory to determine yield curve shape is the liquidity preference theory, which suggests a need for a risk premium to be offered for longer-term bonds to account for their increased interest rate risk and price volatility, as discussed. Since interest rate fluctuations are extremely difficult to predict, the expectations theory alone would probably leave the average yield curve relatively flat. An inverted yield curve where short-term rates exceed long-term rates can be understood as a clear expectation that short-term interest rates will fall in the future. Buy a one-year bond and then reinvest in a new one-year bond after one year, continuing with a succession of ten one-year bonds.įor markets to be in balance, these two strategies should offer the same expected return to an investor, meaning that the combined impact of one-year rates over ten years should match the rate for a ten-year bond.
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