Breakeven Inflation Research Articles

U.S. macroeconomic news and low-frequency changes in bond yields in Canada, Sweden and the U.K.

This paper investigates the importance of U.S. macroeconomic news in driving low-frequency fluctuations in the term structure of interest rates in Canada, Sweden, and the U.K. We follow two complementary approaches: First, we apply a regression-based framework that aggregates the impact of daily macroeconomic news on bond yields to a lower quarterly frequency. Next, we estimate a macro-finance affine term structure model linking the daily news to lower-frequency changes in bond yields and its expectations and term premia components. Both approaches show that U.S. macroeconomic news is an important source of lower-frequency quarterly fluctuations in bond yields in these open economies, and even more important than their respective domestic macroeconomic news. Furthermore, the macro-finance model shows that U.S. macroeconomic news is particularly important in explaining low-frequency changes in the expectation components of the nominal, real, and break-even inflation rates.

On the resilience of cryptocurrencies: A quantile-frequency analysis of bitcoin and ethereum reactions in times of inflation and financial instability

This study examines the resilience of Bitcoin and Ethereum to inflation and financial instability amidst major economic and political disruptions, including the U.S.-China trade war, the COVID-19 pandemic, the Ukrainian conflict, the collapse of Silicon Valley Bank, and the ensuing energy crisis. We employ wavelet coherence analysis and the quantile coherence method to unravel the complex relationship between these cryptocurrency prices, the 5-year breakeven inflation rate, and the U.S. Financial Stress Index (FSI), utilizing daily data from April 16, 2018, to April 14, 2023. Our results reveal that during turbulent times, investors adjust their Bitcoin holdings in response to inflation expectations, driving up Bitcoin prices in both the short and long term. However, Bitcoin’s effectiveness as an inflation hedge diminishes in bearish market conditions, and it proves unreliable as a hedge against financial instability. The relationship between Ethereum and inflation expectations is found to be more context-dependent. Also, while Ethereum’s vulnerability to financial instability is less persistent in the long run, it increases in bearish markets.

Mutual fund flows and government bond returns

We investigate daily flows to Israeli government bonds mutual funds, which are held primarily by retail investors. We divide the bonds into six categories: nominal/CPI-linked - short-term, intermediate-term, and long-term maturity. We find that unexpected daily net flows are contemporaneously correlated with price changes in all categories, with correlations ranging from 0.094 to 0.221 depending on the bond category. These price changes are significant, and they subsequently reverse fully or mostly within 10 trading days. The price reversal indicates that the initial price changes are due to “price pressure.” We find that these price distortions affect break-even inflation—a measure of inflation expectations. Our findings indicate that even government bonds are affected by retail price pressure.

A non-knotty inflation risk premium model

ABSTRACT In this article, I estimate the inflation risk premium (IRP) using a low-dimensional arbitrage-free dynamic model through a novel strategy. Instead of modelling the nominal and real yields jointly, I make assumptions about the short-term inflation rate. More specifically, I assume it follows a Gaussian process. This framework has a closed-form expression for IRP. Since inflation yields are not observed, to estimate the model parameters I approximate them by the break-even inflation rate. This approximation works well because the convexity correction is very small. I find that the estimated IRP is strongly correlated with those obtained using surveys or more complex models. Therefore, I provide an easier procedure to obtain IRP, avoiding the cumbersome estimation process of high-order models.

Inflation Risk Premium

A simple consumption-based model implies that the inflation risk premium should be high when inflation and growth are more negatively correlated, and vice versa. The authors calculate two measures of inflation risk premium: One is the difference between breakeven inflation and survey-based inflation expectations, and the other is the correlation between survey-based growth and inflation forecasts. They show that both measures imply a small inflation risk premium in recent years. Furthermore, the two measures tend to be positively correlated with each other.

Seeking Improved Yield: How to Make SEC Yield More Suitable for TIPS

Inconsistent application of the SEC Yield formula to calculate TIPS bond mutual fund and TIPS bond ETF yields can lead to misleading yield reporting. This article recommends two adjustments to make the SEC Yield calculation more suitable for comparing TIPS bond fund performance. First, apply the break-even inflation rate to re-express each TIPS bond’s real yield as an equivalent nominal yield. Second, use the nominal yield to maturity to calculate 30 days’ interest income, but do not add the monthly inflation adjustment to the TIPS bond’s principal amount.

Break-even inflation rates: the Italian case

PurposeThis work aims to study the break-even inflation rates (BEIRs), a widely used market-based measure of expected inflation. The authors focus on Italian Government bonds, one of the most liquid debt markets in the euro area.Design/methodology/approachThe authors set up an auto-regressive distributed lag model and regress the BEIR on a set of variables that proxy inflation, market risk aversion, protection against deflation, credit as well as liquidity risk to get some insights into the importance of these factors. Subsequently, to disentangle market participants’ inflation expectations from their associated risk premia, the authors estimate a term structure model for the joint pricing of the Italian Government’s nominal and real yield curves, considering also a credit and a liquidity pricing factor.FindingsThe results show that BEIRs could be a misleading measure of the expected inflation due to the importance of the inflation risk premium and the credit risk effect. According to the estimates, the decrease of market-based measures of inflation observed in the last part of the sample period seems to reflect a lowering of both inflation expectations and risk premia. Inflation premia co-move with a measure of the tail risk of the long-term inflation distribution, signalling that investors become more concerned with downside risks.Originality/valueThis study complements the existing literature primarily based on the USA and euro area data focusing on the Italian market. To this end, the authors modify and adapt a well-known term structure model developed for nominal and real curves.

Predicting Market Inflation Expectations with News Topics and Sentiment

This study presents a novel approach to incorporating news topics and their associated sentiment into predictions of breakeven inflation rate (BEIR) movements for eight countries with mature bond markets. We calibrate five classes of machine learning models including narrative-based features for each country, and find that they generally outperform corresponding benchmarks that do not include such features. We find Logistic Regression and XGBoost classifiers to deliver the best performance across countries. We complement these results with a feature importance analysis, showing that economic and financial topics are the key performance drivers in our predictions, with additional contributions from topics related to health and government. We examine cross-country spillover effects of news narrative on BEIR via Graphical Granger Causality and confirm their existence for the US and Germany, while five other countries considered in our study are only influenced by local narrative.

The Effect of Retail Sentiment on Government Bonds

We investigate daily flows to Israeli mutual funds, which are held primarily by retail investors. We find that daily net flows are contemporaneously correlated with price changes of all government bond categories (nominal/CPI-linked; short-term, intermediate-term, and long-term maturity). These price changes are subsequently reversed fully or partially within three months. The price reversals indicate that the initial price changes are due to “noise”. We find that these price distortions affect break-even inflation – a popular measure of inflation expectations. Our findings indicate that even securities that are held by institutions and professional investors are affected by retail sentiment.

Why Does the Fed Move Markets so Much? A Model of Monetary Policy and Time-Varying Risk Aversion

We build a new model integrating a work-horse New Keynesian model with investor risk aversion that moves with the business cycle. We show that the same habit preferences that explain the equity volatility puzzle in quarterly data also naturally explain the large high-frequency stock response to Federal Funds rate surprises. In the model, a surprise increase in the short-term interest rate lowers output and consumption relative to habit, thereby raising risk aversion and amplifying the fall in stocks. The model explains the positive correlation between changes in breakeven inflation and stock returns around monetary policy announcements with long-term inflation news.

Break-even Inflation Rates: The Italian Case

This paper focuses on break-even inflation rates (BEIRs), a widely used market-based measure of expected inflation, computed from government bonds. In the first part of the paper, we regress the Italian BEIR on several financial variables to assess the contribution of inflation, credit and liquidity components. In the second, in order to disentangle market participants’ inflation expectations from risk premia, we estimate a term structure model for the joint pricing of the Italian nominal and real yield curves, considering also credit and liquidity factors. The results show that BEIRs could be a misleading measure of the expected inflation due to the importance of inflation risk premium and credit risk effect. According to our estimates, the decrease in market-based measures of inflation observed in the last part of the sample period seems to reflect a lowering of both inflation expectations and risk premia. Inflation premia co-move with a measure of tail risk of the long-term inflation distribution signalling that investors become more concerned with downside risks.

Oil and Inflation Compensation: Evidence from Treasury Inflation-Protected Security Prices

Why did the correlation between oil prices and 10-year TIPS Break-even Inflation, a measure of long-term inflation compensation, increase dramatically after the financial crisis? Using a shadow-rate no-arbitrage term structure model, we demonstrate that this is because when nominal interest rates bind at the zero lower bound (ZLB), investors doubt the effectiveness of monetary policy to control deflation. As a result, investors adjust their long-term inflation expectations more rapidly after negative oil price changes and pay higher premiums to hedge long-run deflation risks. We explain these findings by a stylized dynamic stochastic general equilibrium model including oil supply shocks, oil demand shocks, and a Taylor rule with the ZLB constraint.

Effects of Fed Policy Rate Forecasts on Real Yields and Inflation Expectations at the Zero Lower Bound

We study the effects of quantitative policy rate forecasts by the Federal Reserve on real yields and inflation expectations at the zero lower bound (ZLB). We study the effects of surprises in policy rate forecasts from the Summary of Economic Projections (SEP) on real yields and breakeven inflation rates derived from government bonds for forward rates across the yield curve. We find that surprises in the SEP policy rate forecasts significantly affect real yields in the expected direction across the yield curve. By contrast, breakeven inflation rates are little affected across the yield curve. In particular, five-year breakeven inflation rates five years ahead, a common measure of monetary policy credibility, are not significantly affected by surprises in SEP policy rate forecasts. This suggests that policy rate forecasts by the Fed at the ZLB managed to affect real yields without adversely affecting monetary policy credibility.

Financial market risk and macroeconomic stability variables: dynamic interactions and feedback effects

This study investigates dynamic interactions and feedback effects between financial market risk proxied by VIX and key macroeconomic stability variables that include the rate of unemployment, headline inflation and market-based inflation expectations reflected by the breakeven inflation. We argue that market risk should play a stronger role in macroeconomic modeling and forecasting than it has been recognized thus far in the literature. We employ vector autoregression with impulse response functions, as well as two-state Markov switching tests to examine these interactions on the longest available US monthly data. The empirical tests show that the association between market risk and macroeconomic fundamentals is predominantly neutral at normal, predictable economic conditions. It becomes very pronounced at times of financial distress, in the environment of elevated market risk coupled with uncertain expectations for macroeconomic variables. Shocks in VIX have a longer impact on macroeconomic stability than that generally claimed in the prior literature. The Markov switching tests for CPI and breakeven inflation indicate that households and businesses are concerned primarily about episodes of increasing inflation, while bond market participants worry mainly about declining inflation and deflation.

Why Does the Fed Move Markets so Much? A Model of Monetary Policy and Time-Varying Risk Aversion

We build a new model integrating a work-horse New Keynesian model with investor risk aversion that moves with the business cycle. We show that the same habit preferences that explain the equity volatility puzzle in quarterly data also naturally explain the large high-frequency stock response to Federal Funds rate surprises. In the model, a surprise increase in the short-term interest rate lowers output and consumption relative to habit, thereby raising risk aversion and amplifying the fall in stocks. The model explains the positive correlation between changes in breakeven inflation and stock returns around monetary policy announcements with long-term inflation news.

Inflation expectations and inflation realities: a comparison of the Treasury Breakeven Inflation curve and the Consumer Price Index before, during, and after the Great Recession

Inflation expectations and inflation realities: a comparison of the Treasury Breakeven Inflation curve and the Consumer Price Index before, during, and after the Great Recession

Market risk and market-implied inflation expectations

We examine interactions between market risk and market-implied inflation expectations. We argue that these interactions are asymmetric and varied in time. Specifically, market risk becomes elevated by expectations of either very low or high expected inflation. Market risk does not react to expectations of moderate, stable inflation. In our analysis, market risk is proxied by VIX and market-implied inflation expectations are reflected by five- and ten-year breakeven inflation. We use daily data for 5 and 10 year breakeven inflation and VIX for the sample period January 3, 2003–January 24, 2019 for empirical testing. We employ asymptotic VAR, multiple breakpoint regression and Markov switching tests to examine changeable patterns in these interactions. Our tests indicate prevalence of responses of expected low inflation or deflation to higher market risk, mainly for the 5-year breakeven inflation series. These responses are particularly significant during the run-up and aftermath of the 2008 financial crisis.

Universal regimes for rates and inflation: the effect of local elasticity on market and counterparty risk

The dependence of interest rate volatility on the level of rates has both general macroeconomic significance and direct consequences on computing market risk metrics such as VAR, SVAR or ES, and counterparty credit risk modelling. Such dependence is investigated and viewed in terms of local elasticity. A new regime at low and negative rates with volatility independent of the level of the rates is found, and three other regimes reported by Deguillaume et al. (The nature of the dependence of the magnitude of rate moves on the rates levels: A universal relationship. Quant. Financ., 2013, 13(3), 351–367] are confirmed with more recent data and a larger pool of currencies. A preliminary study into the existence of regimes for break-even inflation is also conducted and indications of regimes are found. One of these regimes has no equivalence in interest rates; it exhibits negative elasticity slope which may imply a similar regime if rate levels also reach sufficiently negative values. The overall shape of inflation elasticity resembles a strangle payoff, and we hypothesise that this directly reflects markets’ response to macroeconomic policy of inflation targeting and also indirectly links such policy to the nominal rate regimes. We demonstrate that the incorporation of such regimes in market risk modelling improves its predictive capacity, and for counterparty risk modelling has significant impact on risk and regulatory calculations.

Universal Regimes for Rates and Inflation. The Effect of Local Elasticity on Market and Counterparty Risk

The dependence of interest rate’s volatility on the level of rates has both general macroeconomic significance and direct consequences on computing market risk metrics such as VAR, SVAR or ES, and counterparty credit risk modelling. Such dependence is investigated and viewed in terms of local elasticity. A new regime at low and negative rates with volatility independent of the level of the rates is found, and three other regimes reported by Deguillaume, Rebonato and Pogudin (2013) are confirmed with more recent data and a larger pool of currencies. A preliminary study into the existence of regimes for break-even inflation is also conducted and indications of regimes are found. One of these regimes has no equivalence in interest rates; it exhibits negative elasticity slope which may imply similar regime if rate levels also reach sufficiently negative values. The overall shape of inflation elasticity resembles a strangle payoff, and we hypothesise that this directly reflects markets’ response to macroeconomic policy of inflation targeting and also indirectly links such policy to the nominal rate regimes. We demonstrate that the incorporation of such regimes in market risk modelling improves its predictive capacity, and for counterparty risk modelling has significant impact on risk and regulatory calculations.

The Economic Value of TIPS Arbitrage Mispricing

Rational frictionless asset pricing models imply that inflation swap rates and break-even inflation rates with same maturity must be equal. The data, however, suggest a persistent positive difference between these two quantities, which the literature attributes to mispricing of Treasury Inflation-Protected Securities (TIPS). In theory, factors driving TIPS mispricing are not directly observable to the econometrician. To reveal these factors, we analyze the daily term structure of TIPS mispricing and uncover its information content. To assess its economic value, we derive novel high-frequency stylized facts about its dynamics. We document strong relationships with stock market returns, option-implied volatility and variance risk premium, and an important channel for predicting inflation, bond and equity excess returns, jointly.