Breaking Down Breakeven Rates Part 1
Breakeven rates are all the rage these days. The chart below has been posted (and printed) all over the place showing the huge rally in breakeven rates since the lows of March 2020. People are looking at this rally and using it as evidence that the US economy (and by extension the world’s) is on the verge of “boom times!”
Their thinking runs along the lines of: breakeven rates represent market expectations for future inflation, hence higher breakevens = higher inflation. Higher inflation means that the Fed’s (together with, at this point, almost every other major central bank on the planet) QE is working! Add into this talks of a massive fiscal stimulus package from the Biden administration and all of a sudden what had been talk of reflation becomes turbocharged into “boom times”.
Are things really as simple as looking at the yields of some fixed income products and saying that everything is peachy? Of course not, because the global financial system and economy are anything but simple.
Proponents of the “boom times” narrative are conflating two distinct scenarios, inflation and growth, into a single, hyper bullish outcome. But not all inflation is of the kind that indicates robust economic growth. Which begs the question, what kind of inflation is currently being “priced into” breakeven rates?
Let us first begin by understanding what breakeven rates are, how they are calculated, and what they represent. Breakeven rates are the difference between nominal Treasury yields and yields on Treasury Inflation Protected Securities (TIPS), for example:
5 year Breakeven Rate = 5 year Treasury Yield – 5 year TIPS Yield
It is useful to think of this equation as representing the calculation of real interest rates in the economy, real in this case simply meaning adjusted for inflation:
Real Interest Rates = Nominal Interest Rates – Inflation
With a little readjustment, we get:
Inflation = Nominal Interest Rates – Real Interest Rates
When arranged in this way, it is quite easy to see that the breakeven rate is “supposed” to represent the level of inflation; US Treasury yields, nominal interest rates; and US TIPS, real interest rates. Because the breakeven rate is derived from market prices of US Treasuries and US TIPS, it is often thought of as representing market expectations of future inflation.
All in all, the breakeven rate and what it represents is quite easy to understand on an intuitive level, except that all too often people take this intuitive understanding and extrapolate linearly from there, the “boom times” narrative being a good example.
To be continued…
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