Inflation Bonds Are Betting on Team Transitory

Fear of inflation has a partisan flavor: People tend to feel better about economic prospects when their political party is in power and worse when it isn’t.

If investors behaved that way, dread would be registering in the corner of the credit market where the fearful can buy insurance against runaway inflation. After all, the U.S. Personal Consumption Expenditure Core Price Index and Consumer Price Index Urban Consumers Index climbed to 30-year highs of 4.1% and 6.2%, respectively, in 2021. Republicans are using the specter of unchecked inflation to bash President Joe Biden, and plenty of Democrats are jittery, too.

It isn’t happening. Short- and long-term obligations, representing $29 trillion of U.S. debt, including Treasury Inflation Protected Securities created 25 years ago as an inflation hedge, are collectively calculating a CPI over the next 30 years that won't amount to even a percentage point above the 21st-century average of 2.2%.

The breakeven rate, or gap between the yield of an inflation-linked bond and the yield of a traditional Treasury security, doesn't signal anything close to alarm over inflation. The 30-year breakeven rate, measuring the difference between 30-year TIPS and the benchmark 30-year Treasury, is 2.32%, less than the breakeven rate between 2009 and 2013, when the U.S. economy was struggling to recover from the 2008 financial crisis, according to data compiled by Bloomberg.

Breakeven rates historically are higher for longer periods than shorter durations as investors anticipate paying more for goods and services in the distant future. Sure enough, that's the outcome when the 10-year breakeven rate is compared to the two-year breakeven rate between 2010 and 2020. But in 2021, the two-year rate exceeded the 10-year rate, showing that investors are betting that inflation will peak during the next two years and then subside for the next eight. Federal Reserve Chair Jerome Powell says as much in his routine testimony to Congress.

The issuance of TIPS, which now total more than $1.6 trillion on an annual growth rate of 25%, also shows a relative decline compared to the rest of the Treasury market. If inflation is the existential threat to prosperity asserted by so many commentators, the demand for TIPS should be increasing in lockstep with the exchange-traded funds created to purchase them. While the iShares TIPS ETF, the largest measured by assets, saw a 45% increase in demand during the past 12 months, newly issued TIPS were 34 basis points less as a percentage of total Treasury sales during the same period, according to data compiled by Bloomberg.