Breakeven Inflation Research Articles

Breakeven inflation rates and their puzzling correlation relationships

It is generally assumed that the two Fisher components of the interest rate – the real interest and the inflation – evolve independently over time, considering that they are driven by unrelated economical events. However, the market pricing of those components deduced from newly-available bond data does not provide conclusive evidence. While studying the price behaviour of inflation-linked (real) bonds beside nominal bonds in the major fixed-income markets, we observe that the Real Bond Yields (RBY) and the yield differentials, the Breakeven Inflation Rates (BEIR), have the propensity to be positively correlated between each other across the various countries, yet are pushed into a negative correlation relationship due to market-related price distortions. As long as those distortions are local, the net result is near-zero correlation within countries; when they become global, as in the heat of the current crisis, the correlations turn negative worldwide. In this article insight is gained by taking an innovative worldwide study approach and thanks to revealing crisis period events.

Breakeven Inflation Rates and Their Puzzling Correlation Relationships

It is generally assumed that the two Fisher components of the interest rate -the real interest and the inflation- evolve independently over time, considering that they are driven by unrelated economical events. However, the market pricing of those components deduced from newly-available bond data does not provide conclusive evidence. While studying the price behavior of inflation-linked (real) bonds beside nominal bonds in the major fixed-income markets, we observe that the real bond yields and the yield differentials, the breakeven inflation rates, have the propensity to be positively correlated between each other across the various countries, yet are pushed into a negative correlation relationship due to market-related price distortions. As long as those distortions are local, the net result is near-zero correlation within countries; when they become global, as in the heat of the current crisis, the correlations turn negative worldwide. In this paper insight is gained by taking an innovative worldwide study approach and thanks to revealing crisis period events.

Inflation expectations from index-linked bonds: Correcting for liquidity and inflation risk premia

We propose a novel method to correct break-even inflation rates derived from index-linked bonds for liquidity and inflation risk premia without resorting to survey based measures. In a state-space framework the difference between break-even inflation rates and unobserved true inflation expectation is explained by measures of time-varying liquidity and inflation risk premia. Our results have better forecasting performance for the average annual inflation rate over the following 10 years than raw break-even rates and the Survey of Professional Forecasters.

A Model-Independent Maximum Range for the Liquidity Correction of TIPS Yields

The difference between nominal and real Treasury yields, also known as break-even inflation (BEI), is biased as a measure of inflation expectations and the associated risk premium due to liquidity differentials between nominal and real yields. In this paper, we use the additional information in inflation swap rates to construct a model-independent measure of the maximum range for the liquidity correction to real Treasury yields – also known as Treasury Inflation-Protected Securities (TIPS). In the empirical analysis, using the model of nominal and real yields introduced in Christensen, Lopez, and Rudebusch (2010), we show how the maximum range of liquidity-corrected TIPS yields converts into a maximum range for the estimated inflation expectations and their associated risk premium. We exploit the admissible range for the estimated inflation risk premium (IRP) to calculate a conservative measure of the benefit of TIPS to the U.S. Treasury by taking the smallest estimated IRP and deducting the maximum TIPS liquidity premium as well as the on-the-run nominal premium. At the ten-year maturity, the average of this measure over our sample is 7 basis points, leading us to conclude that the U.S. Treasury has benefited from issuing TIPS.

Inflation Forecasts Using a Nelson-Siegel Representation of Nominal and Real Yield Curves

he aim of this paper is to evaluate the performance of inflation forecasts backed out from the nominal and real yield curves in the United Kingdom. We use the Nelson-Siegel (NS) framework to model the break-even inflation term structure, and we also consider the one-day break-even inflation derived from NS parameters. In both cases we fit (vector) autoregression models, some of which are augmented by nominal and/or real Cochrane-Piazzesi factors. The paper provides three main results. First, parsimonious models based on the one-day break-even inflation outperform other models in forecasting inflation out-of-sample. Second, we quantify the parameter uncertainty, showing that it may have considerable impact on inflation forecasts, in particular after the Lehman Brothers event. Third, model-free forecasts directly obtained from break-even inflation rates are typically hard to beat by parametric alternatives.

Inflation Expectations and Risk Premiums in an Arbitrage‐Free Model of Nominal and Real Bond Yields

Differences between yields on comparable‐maturity U.S. Treasury nominal and real debt, the so‐called breakeven inflation (BEI) rates, are widely used indicators of inflation expectations. However, better measures of inflation expectations could be obtained by subtracting inflation risk premiums (IRP) from the BEI rates. We provide such decompositions using an affine arbitrage‐free model of the term structure that captures the pricing of both nominal and real Treasury securities. Our empirical results suggest that long‐term inflation expectations have been well anchored over the past few years, and IRP, although volatile, have been close to zero on average.

Inflation Expectations and Risk Premiums in an Arbitrage-Free Model of Nominal and Real Bond Yields

Differences between yields on comparable-maturity U.S. Treasury nominal and real debt, the so-called breakeven inflation (BEI) rates, are widely used indicators of inflation expectations. However, better measures of inflation expectations could be obtained by subtracting inflation risk premiums from the BEI rates. We provide such decompositions using an estimated affine arbitrage-free model of the term structure that captures the pricing of both nominal and real Treasury securities. Our empirical results suggest that long-term inflation expectations have been well anchored over the past few years, and inflation risk premiums, although volatile, have been close to zero on average.

The Relationship Between Oil Prices and Breakeven Inflation Rates

This paper explores the role of oil prices in the inflation-linked bond markets. Early proponents of inflation-linked bonds highlighted their role in protecting against future inflation, portfolio diversification, asset-liability matching, and use as a commitment tool for monetary policy in keeping inflation contained. From an investment perspective, real return assets should be attractive in prolonged periods of high inflation and unattractive in periods of low inflation resulting in increased demand for real return assets as inflation expectations grow and decreased demand as such expectations diminish. The late 1990s and early 2000s saw an expansion in the inflation-linked bond markets, with more sovereign issuers, increased issuance size and a wider range of maturities; this tremendous growth in turn fueled greater interest and participation in these markets. After a prolonged period of low and stable inflation, the rise in oil prices that began in 2003/4 coincided with the rapid expansion of the inflation-linked bond markets and the start of the Federal Reserve’s tightening cycle. In addition, the widening of the yield spread between nominal and inflation-linked bonds, or “breakeven”, during this time was seen as an indication that inflation expectations were on the rise. Much of the runup in breakevens was attributed to the observed increases in oil prices. Yet despite similar trends, over most of the sample period, breakevens and oil have not moved one-for-one. Recently, however, the decline in oil prices has coincided with a dramatic decline in breakevens and unprecedented Fed easing. The results demonstrate that the coincidence of breakeven and oil price fluctuations is a relatively recent phenomenon, unique to the US market, and mainly associated with the front end of the breakeven curve.

The Impact of News on the Term-Structure of Breakeven Inflation

We present estimates of the impact of major macroeconomic announcements on two measures of U.S. forward breakeven inflation (the rate of realized forward inflation that leaves an investor equally well off whether he/she holds a nominal or indexed forward investment.) One set of measures is derived from discount curves fit to U.S. Treasury securities and the other set is calculated using inflation swaps. We find that forward breakevens across the maturity structure for both breakeven measures rise with surprises to core CPI, employment, and oil futures and that those responses are broadly similar across the breakeven measures. The reactions of inflation swap breakevens are less precisely estimated and are more variable than the reactions of treasury curve based breakevens. Stability tests find a break in the summer of 2008, which we interpret as separating the period before the worst market disruptions of the 2008 crisis from the crisis period itself.

The Term Structure of Inflation Expectations

We present estimates of the term structure of inflation expectations, derived from an affine model of real and nominal yield curves. The model features stochastic covariation of inflation with the real pricing kernel, enabling us to extract a time-varying inflation risk premium. We fit the model not only to yields, but also to the yields' variance-covariance matrix, thus increasing identification power. We find that model-implied inflation expectations can differ substantially from break-even inflation rates when market volatility is high. Our model's ability to be updated weekly makes it suitable for real-time monetary policy analysis.

Monetary Independence under Floating Exchange Rates: Evidence Based on International Breakeven Inflation Rates

It is widely assumed that, under flexible foreign exchange (FX) rates, countries may pursue an independent monetary policy with respect to domestic goals. By contrast, recent empirical evidence suggests that, similar to pegs, floating regimes are affected by transmissions of nominal quantities such as inflation or nominal interest rates from abroad. For the case of a four dimensional subsystem of the G7, we highlight the strength of international comovements in liquidity adjusted breakeven inflation interpreted as a measure of future inflation prospects. Results indicate that economies with geographical proximity and strong trade linkages (e.g. Canada and the U.S., the UK and EMU) share highest realized correlations of nonstationary breakeven rates. Moreover, these linkages appear strengthened if corresponding exchange rates are relatively stable or if the respective large economy is in a state of relatively uncertain inflation expectations.

What Drives Euro Area Break-Even Inflation Rates?

What Drives Euro Area Break-Even Inflation Rates?

The Rocky Ride of Break-Even-Inflation Rates

The correlation matrix between break-even inflation rate movements and real interest rate movements across several countries shows puzzling features. Correlation is significantly positive for nearly all cross-border pairs whereas it is nil, positive or negative unsystematically within countries. By means of a correlation matrix decomposition, we provide an explanation for this puzzle.

Price Discovery on Traded Inflation Expectations: Does the Financial Crisis Matter?

We analyze contributions of different markets to price discovery on traded inflation expectations and how it changed during the financial crisis. The quicker information is processed on one market and the less one market is disrupted by the financial crisis the more valuable is its information for central banks and market participants. We use a new high frequency data set on inflation-indexed and nominal government bonds as well as inflation swaps to calculate information shares of break-even inflation rates in the euro area and the US. For maturities up to 5 years new information comes from both the swap and the bond markets. For longer maturities the swap market provides less and less information in the euro area. In the US where the market volume of inflation-linked bonds is large the bond market dominates the price discovery process for all maturities. The severe financial crisis that spread out in Autumn 2008 drove a wedge between bond and swap break-even inflation rates in both currencies. Price discovery ceased to take place on the swap market. Disruptions coming from the short-end of the market even separated price formation on both segments for maturities of up to 6 years in the US. Against the backdrop of the most severe financial crisis in decades contributions to price formation concentrated a lot more on the presumably safest financial instrument: government bonds.

Inflation Risk Premia and Survey Evidence on Macroeconomic Uncertainty

The difference between nominal and real interest rates (break-even inflation) is often used to gauge the market's inflation expectations - and has become an important tool in monetary policy analysis. However, break-even inflation can move in response to shifts in inflation risk premia and liquidity premia as well as to changes in expected inflation. This paper sheds light on this issue by analysing the evolution of US break-even inflation from 1997 to mid-2008. Regression results show that survey data on inflation uncertainty and proxies for liquidity premia are important factors.

TIPS and inflation expectations

Previous research suggests that the market for index-linked bonds is not entirely efficient and that these inefficiencies can be exploited by including inflation forecasts in trades on break-even inflation. Inspired by those results, we test the informational content of inflation expectations using survey data generated by the Survey of Professional Forecasters. We develop trading strategies speculating on the movement of break-even inflation. The results indicate that the market for US inflation-indexed government bonds offers the possibility to obtain excess returns. These results are fairly consistent regardless of market frictions introduced in the return calculation.

The Term Structure of Euro Area Break-Even Inflation Rates: The Impact of Seasonality

This paper provides a toolkit for extracting accurate information about inflation expectations using inflation-linked bonds. First, we show how to estimate term structures of zero-coupon real rates and break-even inflation rates (BEIRs) in the euro area. This improves the analysis of developments in inflation expectations by providing constant maturity measures. Second, we show that seasonality in consumer prices introduces misleading and quantitatively important time-varying distortions in the calculated BEIRs. We explain how to correct for this in the estimation of the term structure, and thus provide a unified framework for extracting constant maturity BEIRs corrected for seasonality.

The Importance of Being Vigilant: Has ECB Communication Influenced Euro Area Inflation Expectations?

Using daily data on inflation-indexed bonds, we find evidence of a negative relationship between ECB communication regarding risks to price stability - measured on the basis of the frequency and strength of the keyword 'vigilance' - and changes in euro area break-even inflation. However, this result is only found for the second half of 2005. At that time, the start of a tightening of ECB monetary policy was increasingly likely. This suggests that communication should be closely in line with policy actions before it can be effective. Still, we also find that the economic significance of this type of communication has been small.

TIPS, Break-Even Inflation, and Inflation Forecasts

This study investigates the efficiency of the U.S. market for inflation-indexed government bonds using a signal based on inflation forecasts and evaluating the effectiveness of several trading strategies to provide abnormal returns. The market for U.S. TIPS offers the possibility to obtain excess returns if information about future inflation is combined with a trading strategy speculating on the movement of break-even inflation. These results are fairly consistent over time for the shorter maturity. Index-linked government bonds can be considered an asset class with idiosyncratic characteristics that make them an important part of an investment portfolio.

European Inflation-Indexed Government Debt Security Markets

The U.K. was the first industrialized country to issue index-linked government bonds. France has joined this group of issuers recently with two series indexed either to French inflation or to inflation in the euro area. This investigation of the efficiency of these markets tests the information content of inflation forecasts to develop trading strategies speculating on the movement of break-even inflation. The results indicate that the market for the French OATi offers the possibility of excess returns, a result that is fairly consistent regardless of market frictions introduced in the return calculation. These trading strategies are beneficial for practitioners tracking index-linked bond indexes in the particular markets.