Predicting the rate of inflation is a crucial part of financial forecasting. Comparing the yield on 10-year Treasury notes with the yield on 10-year Treasury Inflation-Protected Securities (TIPS) can offer valuable insight into how investors view future inflation trends. This comparison is called the "TIPS spread."
- Investors pay close attention to the difference in yield, or the spread, between 10-year U.S. Treasury notes and 10-year TIPS.
- This spread can provide a sense of expectation for future inflation.
- The difference in the spread is often referred to as the "breakeven inflation rate."
- If inflation exceeds the breakeven rate, you are better off owning TIPS. If inflation is lower than that rate, you would be better off owning plain-vanilla Treasuries.
- Over time, 10-year inflation expectations have typically landed in the 2% to 2.5% range, although they have dipped lower than 2% in recent years.
- The TIPS spread isn't a perfect predictor of inflation. Both Treasury and TIPS yields are subject to market forces and investor emotions.
The Spread and Inflation
If the 10-year Treasury has a yield to maturity (the rate of return you would receive over the lifetime of the note) of 3%, and the 10-year TIPS has a yield of 1%, then inflation expectations for the next 10 years are roughly 2% per year. In the same way, you can look at the spreads between Treasuries with maturities of five or 30 years and their corresponding TIPS to get an idea of inflation expectations for those time periods.
The Treasury issues TIPS only with maturities of five, 10, and 30 years.
The spread is also often referred to as the "breakeven" inflation rate. If inflation exceeds the breakeven rate, you would be better off owning TIPS than plain-vanilla Treasuries. If inflation comes in below the breakeven rate, you would be wise to hold Treasuries instead of TIPS.
The History of the TIPS Yield Spread
By looking at a chart of the spread between U.S. Treasuries and TIPS, you can see how investors' inflation expectations have changed over time. The chart below shows the gap between the 10-year maturity of each note from the beginning of 2003 through September 2019. Prior to that, TIPS weren't liquid (easily traded) enough to be able to get an accurate measure of inflation expectations from the spread.
This chart shows that over time, 10-year inflation expectations have typically landed in the 2% to 2.5% range, although they have dipped lower than 2% in recent years. Note the large dip in the spread during the financial crisis of 2007 and 2008, along with the subsequent recovery.
While inflation expectations don't track growth expectations as cleanly as they do in Economics 101 textbooks, periods of crisis or sharp economic contraction often cause investors to become less concerned about inflation. And the recovery in the spread through 2009 and 2010 corresponds with the rebound in global growth and stock prices during that time.
Since then, movements in the bond market have largely reflected the shifting expectations for the U.S. Federal Reserve's quantitative easing (QE) policy, as well as the various crises that hit the market during the recovery. For instance, the dip in the line during 2010 reflects concerns about the European debt crisis, while the decline in 2011 was caused by the debt ceiling crisis and concerns that the U.S. might default on its debt due to its political impasse.
The decline in 2013 occurred in tandem with the market's expectation that the Fed would taper its QE policy. The decline in the breakeven rate in late 2014 reflected worries that the rapid downturn in European inflation would eventually feed through to the U.S. A few years later, the Fed has been slowly tapering, and there is uncertainty about the future of QE. As a consequence, bond yields remain generally low but mixed.
The spread isn't a perfect predictor of inflation. After all, both Treasury and TIPS yields are subject to market forces and, therefore, investor emotions. However, the spread is useful for providing some sense of where inflation expectations are and how they have changed over time.