What is Breakeven Inflation?
Breakeven inflation refers to the difference between the nominal interest rate on fixed-income security and the real interest rate derived from an inflation-protected security with the same maturity.
In other words, it is the level of inflation that would cause the return on an inflation-protected security to be equal to the return on a fixed-income security.
For example, suppose a 10-year Treasury bond yields 2%, and a 10-year Treasury inflation-protected security yields 0.5%.
The difference between these two yields is 1.5%, which is the breakeven inflation rate. If inflation exceeds 1.5% over the next 10 years, the return on the inflation-protected security will be higher than the fixed-income security.
Breakeven inflation is an important indicator of market expectations for future inflation. Investors use breakeven inflation rates to gauge the market’s view on inflation over different time horizons.
A higher breakeven inflation rate implies that investors expect higher inflation in the future, while a lower breakeven inflation rate suggests the opposite.
Breakeven Inflation Calculation
Breakeven inflation can be calculated by minus the nominal yield on a fixed-income security with the real yield on an inflation-protected security
Breakeven Inflation Rate = Nominal Yield on a Fixed-Income Security – Real Yield on an Inflation-Protected Security
- The nominal yield on fixed-income security represents the interest rate that the security pays out to the investor, without adjusting for inflation.
- The real yield on an inflation-protected security, on the other hand, reflects the interest rate that the security pays out after adjusting for inflation.
For example, suppose a 10-year Treasury bond yields 2% and a 10-year Treasury inflation-protected security yields 0.5%. Using the above formula, we can calculate the breakeven inflation rate as follows:
Breakeven Inflation Rate = 2% – 0.5% = 1.5%
This means that if inflation exceeds 1.5% over the next 10 years, the return on the inflation-protected security will be higher than the fixed-income security. Conversely, if inflation is lower than 1.5%, the fixed-income security will outperform the inflation-protected security.
Why the Breakeven Inflation Rate Matters
Breakeven inflation tells us about market expectations for future inflation over a particular time horizon. It is the difference between the nominal yield on a fixed-income security and the real yield on an inflation-protected security with the same maturity.
A higher breakeven inflation rate implies that investors expect higher inflation in the future, while a lower breakeven inflation rate suggests the opposite.
This can be useful for investors, economists, and policymakers who are interested in understanding market expectations for inflation and how they may affect investment decisions, economic growth, and monetary policy.
Breakeven inflation is also a key input in pricing inflation-linked securities and can provide valuable information about inflation expectations for bond issuers and investors. Additionally, breakeven inflation can be used to estimate the market’s implied inflation forecast, which can be compared to other inflation forecasts produced by government agencies or private forecasters.
