Inflation: One Way or Another
08 February, 2019
Source: Bloomberg, Feb 7, 2019. * Note: Projected inflation rates are based on the yields of 5-year U.S. Treasuries and 5-year U.S. Treasury Inflation-protected Securities (U.S. TIPS). Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
The Bottom Line
For better or worse, inflation expectations are on the rise, according to one segment of the bond market closely watched by investors worldwide.
That segment was created in 1997 with the issuance of U.S. Treasury Inflation Protected Securities, or “TIPS”, whose principal increases or decreases based on the Consumer Price Index (CPI).
Comparing the yields of 5-year TIPS to 5-year U.S. Treasuries – both of which reflect market expectations of yields five years into the future allows the calculation of a "breakeven inflation rate”, the rate of inflation at which the yield of TIPS is equivalent to the yield of Treasuries that don’t explicitly adjust for inflation.
For much of 2018, the breakeven rate suggested inflation would meet or beat the Fed’s inflation target of 2% over the coming five years. But that began to change in Q4, as skepticism rose about the U.S. economy’s ability to continue its record-setting growth rate in the face of the Fed’s projected rate hike schedule.
Inflation expectations continued to sink after the Fed’s December 19th reaffirmation of its plans, only to reverse themselves yet again at the very end of the year as interviews and speeches by members of the FOMC dropped clear hints that change was in the wind.
By the time the FOMC met at the end of January, breakeven rates had resumed their upward path; the Fed’s dovish tilt at its January 30th meeting seemed to ratify the market’s verdict about what it would take to maintain the economy’s progress.
U.S. Treasury inflation protected securities (TIPS) are a special type of Treasury note or bond that offers protection from inflation. Like other Treasuries, an inflation-indexed security pays interest six months and pays the principal when the security matures. The difference is that the coupon payments and underlying principal are automatically increased to compensate for inflation as measured by the CPI. Also referred to as “Treasury inflation-indexed securities.”
The Consumer Price Index (CPI) measures the average change in U.S. consumer prices over time in a fixed market basket of goods and services determined by the U.S. Bureau of Labor Statistics.
The 5-year, 5-year forward breakeven inflation rate is a measure of expected inflation derived from "nominal" Treasury securities and their "real" counterparts—inflation-protected TIPS securities.
The Federal Open Market Committee (FOMC) is a policy-making body of the Federal Reserve System (Fed) responsible for the formulation of a policy designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
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