So You Want To ‘Breakeven’?

By Kevin Muir of “The Macro Tourist” fame; reposted here with permission

I suspect in the coming years, we will hear much more about inflation protected securities (TIPS), and the accompanied derived breakeven rate. It is sometimes confusing to understand how nominal rates, real yields (TIPS yield rate) and breakevens all relate to one another, so I have made up a chart to help visualize the relationships.

The white series is the nominal 10-year t-note yield. This is the yield-to-maturity of a standard treasury security. The orange line is the yield-to-maturity for the equivalent TIPS security. The reason the TIPS yield is less than the regular t-note yield is that not only does a TIPS investor earn the quoted rate, but cash flows are augmented with the rate of inflation over the life of the security. Therefore, the difference between the white line (nominal yield) and the orange line (real yield) represents the market’s expectations of inflation. This is called the breakeven rate. If future inflation ends up being higher than the breakeven rate, then a TIPS investor will outperform a regular bond investor and vice versa.

Let’s spend some time going over the history of the different 10 year rates. At the turn of the century, nominal 10-year rates were 6%, real rates were 4% and breakevens were 2%. As the Dotcom bubble burst, nominal rates declined to 3.5%, with real rates basically following tick for tick, thus keeping breakevens stuck at 2%.

In the ensuing economic recovery, as Greenspan kept his foot firmly planted on the accelerator, all rates crept higher, but at the margin, nominal rates rose faster than real, driving up breakevens to 2.5%.

Then, even as the economy started rolling over, breakevens stayed at 2.5%, and it wasn’t until the Great Financial Crisis entered its panic phase that these relationships completely broke down. And man did stuff break…

Look closely at 2008. Nominal rates collapsed from 4% to 2%, but real yields actually rose! This had the effect of driving 10-year breakeven inflation rates to 0%! Think about that for a second. The market was predicting NO INFLATION for the following ten years. It gets even more absurd as my understanding is that TIPS cannot subtract return in the event of deflation (although it is a little more complicated due to the fact that inflation is accrued as opposed to paid out with the coupon), but you get the idea. When the market was pricing in a 0% breakeven, it was practically free money to swap into TIPS. It was probably one of the greatest trades of 2008, but since there was so much stupidity occurring during this period, it is often glossed over.

Once Bernanke responded with his various QE programs, as would be expected, real rates were driven way down (below zero for 2011 and 2012) and breakeven rates rebounded to more normal levels.

But then have a look at the 2015 oil-crisis-induced collapse in rates. Breakevens went from 2.2% to 1.25% as energy was monkey hammered lower by the Saudis and the shale guys.

Finally, over the past couple of years, the nominal rate has rebounded, but real yields have been sitting relatively stagnant at 0.50%. This has the effect of increasing breakeven rates.

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What’s the future hold?

Now that we have a basic understanding of how these rates relate to one another, let’s think about what might happen in the future.

We need to be careful because these are market expectations of future rates, not actual returns. So if the market believes inflation is headed higher over the next ten years, then TIPS will be bid versus regular bonds. It might be that the market is wrong, and inflation ends up underperforming the derived breakeven rate, but it would take ten years to determine who was right and wrong.

It’s a little like Keynes’ comment about the financial markets being like a beauty contest (probably not the most politically correct comment, but it was 80 years ago, so let’s cut ole’ JMK a break).

“It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.” (Keynes, General Theory of Employment, Interest and Money, 1936).

We need to determine what the market believes future inflation will be, not what it will actually be.

If you are deflationist and think we are about to experience another repeat of 2008, or maybe even 1929 for the doomsday crowd, then why on earth would you commit to buying a 10-year TIPS yielding 0.49% when you can buy a regular bond yielding 2.54%? In your mind, inflation could end up averaging way less than the implied 2.04% breakeven rate. Therefore TIPS wouldn’t end up losing you money, but the opportunity cost versus regular treasuries would be massive.

But let’s think about the inflationists. Let’s say you believe that inflation is about to head above 3% or maybe even 4%. Obviously owning a regular bond that yields less than inflation is not a good investment. So on a relative basis, TIPS would outperform bonds. Yet what if 10-year real rates rise at the same time? Owning TIPS in an inflationary environment is not a no-brainer win. Imagine that inflation goes to 3% (I know, I know, the 4 d’s – it can’t happen – deflation, debt, demographics, destiny – I get it – just imagine for me please). And what if with this 3% inflation the 10-year nominal bonds goes to 6%? Well, if breakevens follow actual inflation, that would imply a TIPS yield of 3% also. So the TIPS yield will have gone from 0.49% to 3%. This will mean a capital loss.

For the true inflationists, what you want to own is the breakeven rate. In our hypothetical example, what you want to do is play the relative outperformance of TIPS versus the regular t-note.

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How to trade breakevens

But how do you go about getting long inflation? Well, institutions can simply call up the laundry-scammer-turned-head-inflation-trader-at-JPMorgan and enter into an inflation swap. But for those of us without ISDAs, we need to find alternative methods.

I am going to give you two ways. One difficult (but you can use a lot more leverage), and one easy (but it is an illiquid ETF with high fees).

Let’s start with the difficult one.

If we think about the trade, it’s actually quite simple. We want to go long TIPS and short regular treasuries. The key is figuring out the right combination and make sure you get the hedging ratios correct. I am going to use futures on the short side as I won’t need to worry about borrow.

The current on-the-run 10-year TIPS is the 0.375% of 07/15/27. The quote is 98.50 to 98.56 for a yield of 0.536% to 0.529%.

On the other side of the trade, I am going to use the ultra-note 10-year future. The reason I am using the ultra versus the regular 10-year future is that the underlying bond (cheapest-to-deliver) for the ultra matches duration almost perfectly (07/15/27 for TIPS vs. 08/15/27 for ultra).

From there, we need to figure out the hedging ratio.

Lucky for us, Bloomberg does all the math. Here is the position hedging screenshot.

This means that if you were to buy $10MM of TIPS (I know, Bloomberg always assumes we are all George Soros), you would need to short 82 contracts of the ultra-note ($8.2MM notional). For us odd lotters, you could adjust it down by dividing by 10, or even 100.

I can hear the groans now – that’s all fine Mr.Macrotourist, but I don’t want to babysit some TIPS versus futures position. I know, I know… I just wanted to explain how it is done so that when I present the easy option, you understand what’s happening.

For the easier way – I warn you now, this ETF is illiquid – so don’t be running out and be putting in market orders. It’s also based on 30-year rates, so the duration is longer than my previous example.

The ProShares Inflations Expectations ETF [symbol RINF] is a security designed to track 30-year breakeven rates.

The problem with the product is the massive expense fee.

Yet there is no cleaner way to trade breakevens.

And let’s face it, if you are a big bond bear because you believe inflation is about to take off, then either you want to be outright short nominal treasuries, or long breakeven rates. And if you think Central Banks will err on raising rates slower than the market wants, then there is a good chance that inflation expectations outperform short regular duration positions on a risk adjusted basis.

Either way, it’s important to understand the difference between nominal, real and breakeven rates. I hope this helps a little.