Since the introduction of Treasury Inflation Protected Securities (TIPS) in 1997, financial experts have used the quoted yield to maturity on these instruments to determine a “market-driven measure” of expected inflation. In particular, financial analysts have taken the quoted yield to maturity on a given conventional U.S. Treasury security and subtracted the quoted yield to maturity on the similarly matured TIPS. This helps determine expected inflation for the time horizon consistent with the maturity of the two securities. This spread in yields is termed “breakeven inflation” in financial circles.
The primary difference between the two Treasury securities is that the conventional Treasury security has a principal fixed in dollars, whereas the TIPS security has a floating principal tied to the Consumer Price Index (CPI). Since the TIPS has a truly unknown future cash flow, the quoted yield to maturity on TIPS assumes no change in the CPI.
The logic behind the breakeven measure of inflation is that investors in TIPS will be willing to take a lower quoted annual yield on the instrument that is equal to their anticipated annual increase in the CPI. In other words, arbitrage between these two different Treasury instruments should lead to a yield spread equal to the markets’ anticipation of average annual inflation over the maturity of the instruments.
The calculation of breakeven inflation on Inauguration Day for securities with maturities of five years, seven years, ten years, twenty years and thirty years (taken from (Daily Treasury Real Yield Curve Rates)) is shown here:
|January 20, 2021 Yield Curve Comparison|
|5 yr.||7 yr.||10 yr.||20 yr.||30 yr.|
|Treasury Inflation Protected||-1.70%||-1.33%||-1.02%||-0.54%||-0.30%|
On Inauguration Day, breakeven measures of inflation are remarkably similar across maturities, all a little above 2%. These measures suggests that market participants are expecting average annual inflation over the next five years and beyond to be very close to the Federal Reserves stated goal of annual goods and services inflation running 2%, which they term “price stability”. Accordingly, Federal Reserve officials should be very happy, as they have been repeatedly disappointed that inflation in recent years has fallen short of the 2% goal.
One underappreciated feature of these Treasury security quoted yields is that the quoted yield to maturity for the five different TIPS maturities are all negative. This is unusual and means that all TIPS investors are willing to pay a premium above the stated face value of these securities. Interestingly, the size of this premium paid by TIPS investors shrinks as the maturity is extended, yielding an upward-sloped yield curve for TIPS, similar to that of the conventional Treasury security yield curve.
Another unusual feature of the quoted yields is how much of the breakeven inflation measure is attributable to the premium paid on TIPS securities. Indeed, for the five-year horizon, most of the breakeven inflation is attributable to the premium paid on TIPS. For these maturity instruments, almost 80% of breakeven inflation is because the TIPS instrument is selling at a premium. If this TIPS sold at par, breakeven inflation would only be 0.45%.
The decomposition of breakeven inflation for the shorter maturities is consistent with the thought that the Federal Reserve will keep conventional Treasury yields relatively low for an extended period of time. As a result, Treasury security investors can no longer successfully protect themselves against inflation with higher yields on conventional Treasuries. Rather, sophisticated Treasury investors worried about future inflation are buying inflation protection through paying premiums on TIPS for inflation protection.
It is worth emphasizing that if inflation does indeed average 2.15% over the next five years, as suggested by breakeven inflation, an investor in the conventional five-year Treasury will lose an average purchasing power of 1.70% per year.
For longer Treasury maturities, less of breakeven inflation is attributable to the premium on the comparable TIPS instrument. For example, only 14% of the 30-year breakeven inflation measure is due to the small premium paid on the 30- year TIPS. Still, the fact that the conventional yield on the 30-year Treasury is less than breakeven inflation for that maturity again indicates that an investor in this conventional Treasury should expect, once again, to lose some purchasing power on average each year.
Scott E. Hein is an Emeritus Professor of Finance at Texas Tech University.