Breaking Down Breakeven Rates Part 2
It is important to remember that the breakeven rate is not a market based rate. It is derived from market rates of USTs and TIPS, yes, but that does not make the breakeven rate a market rate. What is the difference?
Quite simply, if it were a market rate, participants would be trading it as a financial instrument with the express intention of trying to price inflation expectations. Instead, what we have here is market folks trading USTs and US TIPS, which are two very different instruments, and hence two marketplaces with different types of participants, liquidity levels and supply/demand dynamics. As such, in order to truly understand what the breakeven rate represents, we have to understand what the yields of USTs and US TIPS represent.
UST yields and what they represent can be broadly seen from two perspectives. The first being the world’s willingness to fund the US government given current levels of Treasury supply; and the second, levels of demand for high quality collateral, again relative to current levels of UST supply. Since markets hold the paradigm of USTs being the global risk free rate, UST yields represent the base level of returns for assets, hence Treasury yields are seen as representative of the nominal rate of return (or nominal interest rate).
US TIPS yields, on the other hand, represent investor demand for a rate of return that is protected from inflation (or deflation). This works because of how TIPS are structured as a financial instrument. Instead of the normal periodic fixed coupon payments followed by the repayment of principal, TIPS pay coupons based on a variable principal amount.
For example, if you own $1000 in TIPS that pays a coupon of 1%, and the CPI comes in at 1%, the $1000 principal is adjusted upwards to $1010. The coupon you receive for that time period will then be based on the adjusted principal, which works out to $10.10. Yields on TIPS therefore represent real yields, and demand for TIPS tends to rise when investors expect rises in the CPI, or more broadly, levels of inflation.
It is very important to understand that a rising CPI only indicates higher inflation. It does not differentiate between the different types of inflation – that’s up to the people interpreting the statistic to figure out. This means that looking at TIPS yields in isolation and coming to some kind of conclusion about the state of the economy is way too simplistic.
To be continued…
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