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Sunday, November 10, 2019

U.S. Breakeven Inflation Ticking Up

Chart: U.S. Breakeven Rate and Indexed Yield

The recent rise in Treasury yields has largely been a rising breakeven inflation story. Admittedly, it was not a large move, but the 10-year breakeven appears to have bounced off the 1.5% level.

(The 10-year breakeven inflation rate is the nominal Treasury yield less the quoted yield on the 10-year index-linked TIPS. The breakeven inflation rate is (approximately) the inflation rate required for the 10-year TIPS total return to match the 10-year conventional Treasury total return. This should match forecast average expected inflation under the assumption of market efficiency. My book Breakeven Inflation Analysis provides a deep dive into the issues around this concept.)

It seems clear that recession risks are being taken out of Treasury market pricing. The previous low of 1.5% breakeven inflation seems to have been somewhat aggressive when compared to inflation performance over the past decade (below).
Chart: U.S. CPI Inflation

There is certainly no significant inflation risk premium embedded in the breakeven inflation curve. The current level (near 1.7%) is in the middle of the range of observed inflation rates for the past decade. This is perhaps somewhat surprising this far into an decade-long expansion, but recession fears have meant that risks are seen as symmetric.

Looking forward, it seems likely that breakeven inflation rate movements will explain most of the changes in nominal yields, under the assumption that yield movements are not large. Breakeven inflation rates are still well below their average of recent years, and thus might "re-normalise" closer to 2% if the Treasury bear market continues.

(c) Brian Romanchuk 2019

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