Recovery In U.S. Inflation Breakevens Not Surprising

The rise in breakeven inflation in the United States is not particularly surprising, as it is just a return to projecting previous conditions forward. This could be mistaken, but at this point, the burden of proof is upon those who are pushing a story that inflation will be markedly higher or lower. We can easily see a replay of the dynamics of the past cycle, with President-Elect Biden pursuing similar policies to the administration where he was Vice President, and the Republican Party attempting scorched-earth debt scare tactics to force fiscal tightening.

For readers who are not familiar with the concept of breakeven inflation, it is the nominal yield on a conventional Treasury bond less the quoted yield (indexed, or "real yield") on a matched maturity inflation-linked Treasury (TIPS). I discuss the mechanics of breakeven inflation in my handbook, Breakeven Inflation Analysis. The key observation is that the breakeven inflation rate is (roughly) equal to the required rate of inflation for the TIPS and conventional bond to have the same rate of return when held to maturity -- that is, the TIPS is priced at a break-even level versus the nominal benchmark.

Figure: 10-year U.S. inflation breakeven

The figure above shows the 10-year breakeven inflation rate (based on the Fed H.15 report). We see that the breakeven inflation rate collapsed both this year and in 2008-2009. This was related to a drop in oil prices (an oil price bubble popped in 2008, and West Texas Intermediate futures prices briefly went negative this year). Furthermore, in 2008 being long inflation-linked bonds was an extremely crowded trade (bond market participants were also caught up in the oil price bubble), and the Financial Crisis resulted in forced liquidations (since a breakeven trade is a balance sheet intensive long/short position). Inflation-linked bonds -- like all risky asset classes -- dropped to prices that made no fundamental sense. (This may have happened to a smaller extent in 2020, but I no evidence either way).

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Disclaimer: This article contains general discussions of economic and financial market trends for a general audience. These are not investment recommendations tailored to the particular needs of an ...

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