How to Forecast Expected Inflation Using TIPS

Triston Martin

Oct 11, 2022

Inflation rate forecasting is notoriously difficult, particularly in uncertain economic times. Treasury Inflation-Protected Securities may be used in basic algebra to forecast future Inflation. Understand how to generate inflation estimates using TIPS and get an understanding of the benefits and drawbacks of using them.

How Do TIPS Work?

Inflation-indexed Treasury notes (or "TIPS") are a kind of Treasury note whose value rises with Inflation and falls with deflation. When the CPI changes, so do the value of the securities. Inflation is often measured using the CPI. Like regular Treasury notes (T-notes), investors in TIPS get a set rate of interest twice a year. The bond's after-tax value is used to calculate interest. This benefit is adjusted annually for Inflation. In the very unlikely event of deflation, it would fall. You will get back about the same amount that you initially invested, less the effect of Inflation. In other words, it goes up or down in accordance with the Consumer Price Index. The coupon rate is "real return" over Inflation. Simple T-notes do not have any inflation protection. An increased interest rate is expected from T-bond holders since they bear the whole risk of Inflation's effect on the bond. The potential inflation protection offered by this strategy deserves consideration.

Treasury Notes: An Explanation

Treasury notes, released with maturities of 2, 3, 6, 7, & 10 years, are a prominent investment option and trade on a sizable secondary market. The notes' interest is paid semiannually until they mature. As with a T- bond or bill, interest revenue is subject to federal taxation but not local or state taxation. The United States Treasury issues a variety of debt securities, including notes, bonds, and bills. The time it takes for each to fully mature is the primary dividing line. For instance, a Treasury bond has a maturity range of almost ten years, from twenty years to thirty years rendering it the longest-dated governmental fixed-income asset in the world.

Using TIPS to Predict Inflation

The difference in Yield between a T-note & a TIPS with the same maturity date may be used to estimate a risk premium. As a consequence, investors may see how much inflation protection they should purchase. As an example, if the return on the five-year Treasury note is 3 percent and the return on the five-year Treasury inflation-protected securities is 1%, then annual Inflation over the following five years may be expected to average about 2%. The perspective for certain eras may be gleaned from two- or ten-year editions of a publication. One common term for this disparity is the "breakeven" rate of Inflation. Calculations showing the breakeven rate of Inflation are provided below.

Expected Inflation = Treasury Yield - Tips Yield

You may play about with the calculations in order to get an idea of what T yields would appear to be in the near future, given the pace of Inflation that is anticipated.

Treasury Yield = Tips Yield + Expected Inflation

The same reasoning might be used to calculate yields on TIPS at a certain breakeven inflation rate.

Tips Yield = Treasury Yield - Expected Inflation

The consensus estimate of future Inflation may be determined using this technique. The inflation breakeven hypothesis is just that, a theory. This is due to the fact that the two securities' variances generate market fluctuations, which prohibit this arithmetic from providing an accurate solution.

What Determines the Rate of Expected Inflation?

However, the amount of trade in TIPS is far smaller compared to that of T-notes. A bond's Yield may fluctuate for reasons unrelated to expect future Inflation. Investors' expectations for future Inflation have a major influence on the market value of fixed-income instruments with fixed or floating yields. Consequently, this influences the premium that investors are ready to pay for any form of T-note. For instance, those who wish to invest money might purchase TIPS if they anticipate that the inflation rate at which T-notes will break even will be 1.9%, and they anticipate that Inflation will remain at the Fed's target level of 2%. They might look elsewhere for investment opportunities if the rate needed to break even was greater than the rate of Inflation they anticipated. When using this strategy, you are essentially betting on whether or not Inflation will increase.

Research also indicates that certain estimates of future Inflation are unrealistic. In order to arrive at a figure that is more precise, a few different approaches are being investigated. Considering available cash is one approach. There are flaws in using breakeven inflation to predict future Inflation. It's still a resource that investors may use. It may be useful for predicting potential future outcomes in terms of risk and return.

ETFs Tracking Break-Even Inflation

There are not a lot of different sorts of funds or investments that monitor or utilize the rate to figure out when they will break even. The RINF mirrors the unleveraged gap between TIPS and Treasuries. When investors' hopes for the fund grow, its share price should follow suit. Since this ETF monitors the difference between 10-year Treasury Notes & 10-year Treasury Inflation-Protected Securities, those who invest may trade inflation viewpoints. Don't beat yourself up if you're having trouble keeping up. If the math doesn't make sense, try doing it again. It's a consideration among many individuals who want to maximize the return on their investments.

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