Most Popular ArticlesAugust 4, 2009
To confirm their explanation, the authors studied the behavior of the inflation swaps market following the Lehman bankruptcy. Swaps are transactions used primarily by levered investors, such as hedge funds, where one party pays the other an amount tied to the CPI rate in exchange for receiving a fixed payment. The swaps market confirmed this explanation – a “liquidity” event, with more sellers than buyers, drove down prices.
The authors summarize their findings about the 2008 TIPS episode:
“We view the experience with TIPS yields after the Lehman bankruptcy as the sign of a highly abnormal market situation, where liquidity problems suddenly created severe financial anomalies. This may seem to imply that we can take the recent episode as unrepresentative, and ignore the observations from these dates. And yet, investors in TIPS who would like to regard them as the safest long-term investments must consider the extraordinary short-term volatility that such events have given their yields.”
The 10-year breakeven rate was stable … until 2008
The 10-year breakeven rate represents the difference in yield between nominal and inflation-indexed bonds. If investors anticipate inflation greater than the breakeven rate over the 10-year time horizon, they should hold TIPS; otherwise, they should hold nominal bonds.
The breakeven rate was unstable in the year following the introduction of TIPS, but from 1999 through of the first half of 2008 it was relatively stable, around 2%. It plummeted during the financial crisis, reaching nearly zero at the end of the year – a breakeven rate that reflects an expected lack of inflation over the ensuing 10 years.
This graph also shows the subsequently realized 3-year inflation rate in the blue dashed line. Excepting a drop in realized inflation at the beginning of 2006, these actual inflation rates had tracked fairly closely the anticipated (TIPS) inflation rates since 1999.
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