By Jeremy Rivers, CFP®
Inflation has been a hot topic in 2022 as the Consumer Price Index (CPI) reflected a year-over-year increase of 8.5% in July. Investors have been significantly impacted by inflation this year as market returns have fallen short of the rise in overall price levels.
In difficult inflationary times like this, it is important to be reminded that relief could be on the horizon. Investors can find a more positive outlook on inflation by observing future breakeven inflation rates.
What is Breakeven Inflation?
Breakeven inflation is a market-based measure of expected inflation. The breakeven rate provides a look at possible inflation trends, most commonly five and 10 years in the future. Breakeven is found by comparing the yield of a nominal bond, such as a five-year U.S. Treasury, to an inflation-linked bond of the same maturity, such as a five-year Treasury Inflation-Protected Security (TIPS).
The difference between those two yields is the rate inflation would have to be during that time period for an investor to earn the same return, or “break even,” between both options. For example, suppose the yield on a five-year Treasury is 5% while the yield on a five-year inflation-linked security is 3%. In this case, the breakeven inflation rate would be 2%, meaning market participants expect inflation to average 2% over the next five years.
Why Does Breakeven Inflation Matter?
The breakeven inflation rate provides a look at possible inflation trends in the future. The rate can be used to help investors determine whether Treasuries or TIPS are a better investment for a given time horizon considering the impact of future inflation.
The rate is also used to compare current inflation and future expectations. In irregular inflationary environments, the breakeven rate can show market sentiment as to the direction and duration of extreme inflation. It can also be helpful to investors who wish to outperform inflation in the long term. As shown on the chart below, even though the U.S. experienced a sizeable jump in CPI since January 2021, the five-year breakeven rate has increased by a small margin.
Disparity between the measures widens as focus extends further into the future. The figure below displays the 10-year breakeven rate at 2.47%, 20 basis points lower than the five-year.
This comparison shows that while CPI has been elevated recently, market participants do not expect such severity to continue. As displayed, the market seems to anticipate a significant decrease in inflation in the near term, with numbers continuing to fall in the following years. This can be encouraging for investors, as lower inflation may equate to higher real returns on investments over the next several years.
Hope for Future Price Stability
The U.S. has faced historically high inflation throughout the past several months. Despite current conditions, investors can find hope for future price stability by observing breakeven inflation rates. Keep in mind, breakeven rates are not a guarantee of future inflation. They are simply market-based measures of expectations. While they can be helpful tools, they should not be solely relied upon when making investment decisions.
If you have any questions about breakeven inflation or would like advice on how to position your portfolio for the future, speak to an advisor at Stonebridge Financial Group today.
Jeremy assists clients with creating long-term plans as they become more aware of their personal finances, future needs and how one financial decision impacts another.