As the stock market tumbles a bit from all-time highs, the Treasury market is soaring, with yields dropping to 1.96% yesterday on the 10-year nominal Treasury. It is hard to believe that the US is seeing: 1) better-than-average economic growth, 2) the stock market near all-time highs, 3) ultra-low inflation, and 4) Treasury yields on the decline.
And the market is pricing in very low inflation well into the future. You can see that by calculating the ‘inflation breakeven rate’ – a measure of future inflation expectations – using this simple formula:
10-year Treasury yield – 10-year TIPS yield = 10-year breakeven rate
Here is where inflation breakevens stand today:
- 5 year. 1.47% – 0.31% = 1.16%
- 10 year. 1.96% – 0.39% = 1.57%
- 30 year. 2.52% – 0.68% = 1.84%
While writing about Treasury Inflation-Protected Securities over the last three years, I have devised a simple formula: When the 10-year breakeven rate falls below 2%, TIPS are cheap, when it rises above 2.5%, TIPS are expensive. Here is the breakeven trend for each of the maturities for the last five years:
It’s rare to see inflation breakeven rates this low, and so either the world has permanently changed and inflation will permanently be extremely low, or … TIPS are a bargain right now when compared to nominal Treasurys.
I’d argue that inflation expectations are way too low, especially for the longer maturities. Take a look at this chart of the history of inflation from 1961 to today. Over five-year periods, inflation has never averaged lower than 1.3%; for 10 years, 2.3%, and for 30 years, 2.8%. The chart also shows the US has been in a multi-decade trend of declining inflation. At some point – possibly in the next 10 years and definitely in the next 30 – that trend could change toward gradually rising inflation. Or possibly, sharply rising inflation.
A margin of safety. TIPS investors can take comfort in these extremely low inflation breakeven rates. Why? They provide a margin of safety against rising interest rates. Let’s say the 10-year Treasury rises over the next year to 2.75%, an increase of 79 basis points. At the same time, the inflation breakeven rate rises to 2.2%, a fairly routine number. The 10-year TIPS would then be yielding 0.55%, a rise of only 16 basis points.
When the inflation breakeven trend reverses to ‘more normal’ levels, TIPS are going to outperform traditional Treasurys and probably the overall bond market.
That hasn’t been the case over the last 6 months, as shown in this chart, which is a perfect depiction of the effect of a declining inflation breakeven rate on TIPS: