What Bond Prices may Tell us about Projected Inflation
Wes Crill, PhD Head of Investment Strategists and Vice President
Dimensional Fund Advisors
June 10th, 2022
At some point over the past year, the financial media’s inflation coverage transitioned from, “Will this high inflation persist?” to, “Here’s how to cope with inflation that’s here to stay!” It seems some investors have resigned themselves to a new normal of high inflation following decades of below-average consumer price changes. However, financial market data tells a different story, one of potentially softening inflation.
Breakeven inflation (BEI) rates offer a window into the market’s inflation expectations. Defined as the difference between yields on nominal and inflation-protected bonds of the same maturity, BEI represents the inflation rate at which investors would be indifferent between the two. If actual inflation were to exceed BEI rates, investors would be better off with the inflation-protected bond; if inflation were less than BEI, the reverse would be true. BEI is therefore commonly interpreted as the average annual inflation rate expected over a given time horizon.1
The one-year BEI shows a spike in inflation expectations this year following increasingly high consumer price index (CPI) changes. But the trajectory appears to have changed course over the past couple months (see Exhibit 1). Since peaking at 6.3% in late March, the one-year BEI had fallen to 5.2% as of June 10. This might be the market’s way of telling us it sees inflation getting under control in the near future.
It is important to remember that realized inflation can diverge from expectations. For example, the one-year BEI rate as of May 3, 2021, was just 2.7%. Over the next 12 months, CPI grew by 8.3%, meaning a substantial portion of this inflation seemed to have been unexpected by the market. From January 2007 to April 2022, the difference between actual inflation and that “predicted” by BEI varied from –5.59 to 8.43 percentage points.2
While nominal (i.e., not inflation-protected) bond prices reflect expected inflation, investors who opt for Treasury Inflation-Protected Securities (TIPS) or approaches that overlay inflation swaps (“real return” bond strategies) get compensated for actual inflation. Investors who want to reduce uncertainty in the event of higher-than-expected inflation may benefit from these inflation-hedging approaches.
1. More accurately, the difference in yields between nominal and inflation-protected bonds represents both expected inflation and an inflation risk premium borne by holders of nominal bonds.
2. Based on monthly differences between one-year BEI and subsequent 12-month change in CPI for the period January 1, 2007, through April 30, 2022. CPI data from Bureau of Labor Statistics and is represented by the Consumer Price Index for All Urban Consumer (CPI-U), not seasonally adjusted.
Disclaimer: Past performance is no guarantee of future results. Any indices referenced for comparison are unmanaged and cannot be invested into directly. Investments in securities involve the risk of loss. Nothing in this blog should be considered financial advice or recommendations. Your questions are unique to you and your own personal financial circumstances. You should consult with a financial professional before making a financial decision. See full blog disclaimer.