Economics Help?
The yield on the 10 year T-Note is 4.6%, while the yield on the 10 year TIP (Treasury Inflation Protection Security) is 2.3%. What does this data tell you about financial market investors expectations of the inflation rate over the next few years?
Answer:
The TIP is indexed to the Consumer Price Index (CPI), the main indicator of inflation in the U.S. The interest rate is constant, but the principal amount of the bond is adjusted up or down in line with similar changes in the CPI (virtually always up, as deflation has been nonexistent in the US since the 1930's). So the TPI gives a higher interest payment to offset the measured increase in inflation for each six month period. The downside is that it comes with a lower rate because of this protection.
The difference between the rates (a.k.a. the 'spread') indicates how much of a hit investors are willing to take to cover for the risk of higher inflation. This is related, of course, to investors' perceptions of how the inflation rate is likely to behave in the future. In the example above, investors are willing to give up 2.3% in nominal interest (4.6-2.3) to cover for inflation risk. The simple conclusion is that the market, on average, expects inflation to total somewhere around 2.3% over the next few years.
The situation is actually more complex than that, once you include factors like taxation of interest adjustments and differing risk tolerance for inflation among investors. But this is a fair generalization to start.
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Answer:
The TIP is indexed to the Consumer Price Index (CPI), the main indicator of inflation in the U.S. The interest rate is constant, but the principal amount of the bond is adjusted up or down in line with similar changes in the CPI (virtually always up, as deflation has been nonexistent in the US since the 1930's). So the TPI gives a higher interest payment to offset the measured increase in inflation for each six month period. The downside is that it comes with a lower rate because of this protection.
The difference between the rates (a.k.a. the 'spread') indicates how much of a hit investors are willing to take to cover for the risk of higher inflation. This is related, of course, to investors' perceptions of how the inflation rate is likely to behave in the future. In the example above, investors are willing to give up 2.3% in nominal interest (4.6-2.3) to cover for inflation risk. The simple conclusion is that the market, on average, expects inflation to total somewhere around 2.3% over the next few years.
The situation is actually more complex than that, once you include factors like taxation of interest adjustments and differing risk tolerance for inflation among investors. But this is a fair generalization to start.
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