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Wednesday, February 26, 2020

No Supply Shock In Breakeven Pricing

Chart: U.S. Breakeven Inflation

Although it is early, U.S. inflation-linked bond market is acting in a stereotypical way: underperforming nominal bonds in a rally. This is conforming to the rule of thumb that breakeven inflation is directional: quoted yields on TIPS (real yields, or indexed yields) move less than nominal yields. This is perhaps not too surprising, but one might have expected that behaviour would be different in a supply shock.

(Background: breakeven inflation is the spread between a conventional (nomimal) Treasury that has a fixed coupon, and an inflation-linked bond (TIPS), where the payments are indexed to inflation. I discuss it in my handbook Breakeven Inflation Analysis. It is called breakeven inflation because it is a very good approximation of the inflation rate required for the inflation-linked bond total return to break even with the conventional bond. Breakeven inflation is the best measure of market inflation expectations, although small wedges appear between breakeven inflation and inflation forecasts.)

The figure at the beginning of this article shows spot and forward breakeven inflation (based on Federal Reserve H.15 data). As should be expected, the forward inflation breakeven is falling the most, as shorter breakevens should more sensitive to any near-term price rises due to supply chain disruptions.

The argument justifying the current trend is fairly plausible: supply chain disruptions will presumably be short-lived, while if there are bankruptcies by exposed entities, the world faces another deflationary downturn. Meanwhile. the post-crisis experience has disabused most market participants about the effectiveness of monetary policy to stimulate the real economy. (Many investors believe strongly that central bank interventions are propping up risk asset markets.)

The obvious risk is that investors have fallen to recency bias: they are putting aside the possibility of structural shifts in the economy. Any movement to reverse globalisation would entail inflationary pressures: returning productive capacity to the developed economies would raise price structures, and boost the prospects for workers in the job market. Betting on globalisation reversing has been a loser for the past few decades, so I am definitely not forecasting such an outcome. That said, the insurance value of inflation-linked bonds is probably worth a closer look if present trends continue.

(c) Brian Romanchuk 2020


  1. Thanks for this color re demand/supply and short/long-term expectations.
    Had a question on the definition of underperform/outperform...are you referring to their simple change in yields? Or is it calculated on a beta-adjusted basis? Main reason I ask is that breakeven changes generally tend to exhibit about half the vol of nominal yield changes.

    1. Since it’s a straight spread, it would be maturity/duration matched. Yes, one could position on a beta-matched basis, but somewhat harder to discuss. Since I’m not offering investment advice, not clear why I would look at beta-adjusted performance.

    2. Understood. To be clear, I was not asking for investment advice. I was simply inquiring into what your definition of outperform/underperform was in the context of relative value.

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