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The break-even rate refers to the difference between the yield on a nominal fixed-rate bond and the real yield on an inflation-linked bond of similar maturity and credit quality.


SeekingAlpha writer "Tipswatch" addresses the question: Does TIPS' Inflation Break-Even Rate Accurately Predict Future Inflation?

What people expect and what actually happens are two very different things. The inflation break-even rate measures expected inflation, but it is a lousy predictor of actual inflation. And I have the numbers to prove it.

In 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.

In January 2007, TIPS buyers were getting a gorgeous real yield of 2.45%, but that still ended up being a losing investment versus a nominal Treasury, which was paying 4.76%.

In January 2009, investors were expecting 0.28% inflation over the next 10 years - a remarkably dour number. TIPS were a screaming buy in 2009, yielding 2.25% after inflation versus a nominal yield of 2.52%. But because inflation expectations were so low (and deflation expectations so high), TIPS were shunned by investors.

Buying TIPS is a 'gamble' against inflation expectations, while also providing insurance against unexpected, runaway inflation. If inflation drops to very low levels, the TIPS buyer loses the gamble. If inflation soars higher, the TIPS buyer 'wins'.

The seven underestimates average 0.81% under actual inflation. That's a pretty damning number, indicating that investors' inflation expectations are often far from reality. The four overestimates average 0.41% over actual inflation. Still pretty bad, but I think it's clear that the historical trend in TIPS is to underestimate inflation.

Breakeven Rates Wound Tightly

Lisa Abramowicz chart shows the difference between 30-year and 10-year expectations.

I tried to recreate that chart in Fred but Fred only had monthly, not daily breakeven rates for the 30-year period. On a Monthly basis things are clustered very tightly.

Breakeven Rates 2013-Present

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When was the last time breakeven rates were wound this tightly? Here's the answer.

Breakeven rates 2004-Present

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Stupidity Well-Anchored

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Frequently the Fed makes statements along the lines of "inflation expectations are well-anchored".

I rebutted the notion in Stupidity Well Anchored: Absurdity of Inflation Expectations in Graphic Form.

The only thing that’s “well anchored” is the stupidity of the belief that inflation expectations matter.

Asset Irony

People will rush to buy stocks in a bubble if they think prices will rise. They will hold off buying stocks if they expect prices will go down.

People will buy houses to rent or fix up if they think home prices will rise. They will hold off housing speculation if they expect prices will drop.

The very things where expectations do matter are the very things the Fed and mainstream media ignore.

No Reliable Measures

“There is no single highly reliable measure” of longer-run inflation expectations, Fed Governor Lael Brainard told The Economic Club of New York on Sept. 5.

Lovely. She’s also correct. Yet, she proposes to know what to do about it! How idiotic is that?

Deflation or Inflation?

Yesterday, I commented on this Crescat graphic (yellow highlights mine).

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My comment was "The Taylor rule, velocity, inflation expectations, and breakeven rates are all mostly nonsense if not complete nonsense."

What's left?

  • What's left on the inflation side is mostly what's happening right now: Late stage inflation.
  • What's left on the deflation side is mostly long-term secular deflationary forces.
  • Asset bubble burstings are deflationary by definition.

Meanwhile, it is curious that inflation expectations are coiled tightly from seven years through 30 years as if traders expect inflation will be constant over all time frames.

Expect something else.

For further discussion, of the inflation-deflation debate, please see Fed Tightening Cycles Coincide With Bursting of Asset Bubbles: How to Play It.

Mike "Mish" Shedlock