Check inflation with three simple steps you can do yourself
How confident are you about the Fed’s ability to control inflation? If you’re like us, it’s something you frequently think about. To help you better answer this question, here’s a simple way to see what kind of inflation rates are being priced into the fixed income markets.
The breakeven inflation rate between a conventional Treasury bond and TIPS is one way to measure the market expectations regarding future inflation rates.
So how do you calculate a breakeven inflation rate?
If you have access to a Bloomberg terminal, you can find an index for this breakeven inflation rate. But if you don’t, all is not lost. A three-step process can help you approximate the breakeven rate using publicly available data. The video above will walk you through the process or you can follow the three steps below:
- Go to the Wall Street Journal and pull the yield of the on-the-run Treasury for the maturity you’re interested in. This provides the most recently issued and frequently traded Treasury security for its maturity. (For example, if you’re interested in the five-year expectation, choose a maturity of around five-years).
- Take the yield for the TIPS with the closest maturity to your Treasury yield. TIPS are Treasury Inflation Protected Securities and are essentially identical to Treasury Bonds except the principal and coupon payments are adjusted to reflect the impact of inflation as measured by the Consumer Price Index.
- Compare the difference, or spread, between nominal U.S. Treasuries and TIPS as an approximate breakeven inflation rate. This difference should reflect market expectations of inflation.
This may be a little confusing, so let’s look at an example. To calculate the five-year spread between nominal U.S. Treasuries and TIPS for December 2, 2010, our three steps look like this:
|Yield for Treasuries with a five-year approximate maturity (11/30/15)||1.670%|
|Yield for TIPS with a five-year approximate maturity (1/15/16):||0.081%|
Keep in mind, this is an approximate calculation, so don’t worry if the maturities don’t exactly line up. In the example above, the five-year breakeven inflation rate of around 1.589% feels low and not above the levels of inflation that investors have come to expect over the past 20 years. Values higher than 2-3% could mean the market is expecting higher inflation. So, while Russell as a firm doesn’t believe that inflation expectations in the near term are serious, this is another way to see, directionally, what the market is pricing in going forward.