Measuring Expected Inflation with Breakevens

Central banks in recent years have paid a lot of attention to “inflation expectations” when setting monetary policy. But measuring these expectations isn't always easy. Expectations can vary widely depending on whether you're asking businesses, households, or professional forecasters. One of the more straightforward methods for gauging inflation expectations is by analysing bond market data. This post provides a quick rundown of how this works.px.gif

Bond market-based measures of inflation expectations are known as “breakevens”. These breakeven rates provide a snapshot of what investors anticipate inflation will be over a specific timeframe. To calculate a breakeven rate, we compare the yield of an inflation-protected government bond (such as US TIPS) with a nominal government bond of the same maturity. The difference between these two yields represents the breakeven inflation rate, or the rate at which an investor would earn the same return whether they bought an inflation-protected bond or a nominal bond.

Examples

Using data from the U.S. 5-year Treasuries available on the St. Louis Fed's FRED database, we calculate the breakeven rate as follows:

5-Year Breakeven Inflation Rate (T5YIE) = Yield on 5-year US Treasury (DGS5) – Yield on 5-year US Treasury Inflation-Indexed (DFII5)

As of 8 August 2024, the yield on a 5-year US Treasury is 3.83%, while the yield on an inflation-indexed 5-year US Treasury stands at 1.85%. This translates to a breakeven rate of 1.98% (3.83% – 1.85%).

breakeven5yr.png

Let's repeat this for 10-year US Treasuries:

10-Year Breakeven Inflation Rate (T10YIE) = Yield on 10-year US Treasury (DGS10) – Yield on 10-year US Treasury Inflation-Indexed (DFII10)

As of 8 August 2024, the yield on a 10-year US Treasury is 3.99%, while the yield on an inflation-indexed 10-year US Treasury is 1.87%. This yields a breakeven rate of 2.12% (3.99% – 1.87%).

breakeven10yr.png