TIPS and the Breakeven Rate the Market Uses to Forecast Inflation
Inflation protected Treasuries adjust their principal with the price index. Comparing them to ordinary Treasuries produces a market based inflation expectation, updated continuously.
The Instrument
Treasury Inflation Protected Securities, or TIPS, are government bonds whose principal adjusts with the Consumer Price Index. If prices rise 4 percent over a year, the principal rises by roughly the same amount, and the fixed coupon rate is applied to that larger principal.
The result is that the coupon payment grows with inflation and the final redemption is in inflation adjusted dollars. The investor is compensated in purchasing power rather than in nominal dollars.
An ordinary Treasury makes no such adjustment. Its 4 percent coupon is 4 percent whether inflation runs at 1 percent or 8 percent, which is exactly the risk it leaves with the holder.
Real Versus Nominal
The yield quoted on a TIPS is a real yield: a return above inflation, whatever inflation turns out to be. The yield on an ordinary Treasury is a nominal yield, containing both a real return and compensation for expected inflation.
Subtract one from the other and you isolate the inflation piece.
The Breakeven
If a ten year Treasury yields 4.1 percent and a ten year TIPS yields 1.8 percent, the breakeven inflation rate is 2.3 percent.
The name describes what it is. If inflation averages exactly 2.3 percent over the decade, both bonds deliver the same return. Above that, the TIPS wins. Below, the nominal Treasury wins.
The breakeven is not a survey or a forecast published by an institution. It is the rate at which people trading real money are indifferent between the two bonds, and it updates every second the market is open.
What It Is and Is Not
The breakeven is treated as the market's inflation expectation, and it is close to that, with two caveats.
It contains an inflation risk premium. Investors dislike inflation uncertainty and will pay something to avoid it, which pushes the breakeven slightly above true expected inflation.
It also contains a liquidity premium running the other way. The TIPS market is far smaller than the nominal Treasury market and trades less freely, so TIPS yields carry an illiquidity discount that pushes measured breakevens down. In stressed conditions this dominates. In March 2020 breakevens collapsed far more than any reasonable revision to inflation expectations would suggest, because the TIPS market seized while the nominal market kept functioning.
Reading the Curve
| Measure | What it captures |
|---|---|
| 5 year breakeven | Near term inflation path |
| 10 year breakeven | Medium term average |
| 5 year, 5 year forward | Expectations excluding the next five years |
The last one is the measure central bankers watch. It strips out the current inflation episode and asks what the market expects afterwards. If near term breakevens spike while the forward measure stays anchored, the market is saying this is a shock rather than a regime change. If the forward measure moves, that is the market questioning the credibility of the inflation target, which is a far more serious signal.
The Practical Drawbacks
TIPS have real disadvantages for an individual holder. The inflation adjustment to principal is taxable in the year it occurs, even though no cash is received until maturity, producing a tax bill on money you do not have yet. This is why they are usually recommended for tax sheltered accounts.
They are also still bonds, so a rise in real yields produces a capital loss regardless of inflation. In 2022 TIPS lost value even during high inflation, because real yields rose sharply. They protect against inflation, not against rate moves, and holders who conflated the two were surprised.
The Bottom Line
TIPS index their principal to inflation, so their yield is a real return. The gap between them and ordinary Treasuries is the breakeven, a continuously updated market estimate of expected inflation, distorted somewhat by risk and liquidity premiums. It is one of the most useful numbers in macro, provided you remember it prices expectations and liquidity together, not expectations alone.