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Inflation Expectations and Breakevens: What the Bond Market Predicts

Central banks watch not only current inflation but what people expect it to be. Expectations influence wages and prices, so they influence policy.

One market-based measure is the breakeven inflation rate. It is the difference between the yield on a regular government bond and the yield on an inflation-linked bond of the same maturity. If a ten-year nominal bond yields 4.0 percent and the inflation-linked equivalent yields 1.8 percent, the breakeven rate is 2.2 percent, which is roughly the average inflation the market is pricing in over ten years.

Surveys offer another view. Households, businesses, and professional forecasters are asked about expected inflation, and the results are published regularly. Central banks pay special attention to longer-term expectations, because stable ones suggest credibility.

Currency relevance comes through policy. If expectations rise sharply, the central bank may feel pressure to tighten, which can support the currency, provided the market trusts the bank to act. If expectations rise while the bank appears hesitant, the currency may weaken, because real yields fall.

Breakevens also include risk premiums and liquidity effects, so they are not pure forecasts.

Monitoring the five-year and ten-year breakevens alongside nominal yields gives a rough read on whether moves in yields come from growth or inflation.

Practical step: look up the current ten-year breakeven rate for one economy, and compare it with the central bank's inflation target.

Comparing the five-year with the ten-year breakeven is a nice touch. If short-term expectations jump but long-term stay put, markets think the central bank still has it under control. The five-year five-year forward rate is another one worth knowing. It strips out the next five years and shows what markets expect for the five years after that, which is closer to a test of central bank credibility. The St Louis Fed's FRED site has all three as free daily series for the US. Putting them on one chart once a week takes a minute and gives you a sense of whether a hot CPI print is being treated as temporary or as a shift.

Worth remembering breakevens can move just because liquidity in inflation-linked bonds dries up. Not every move is a change in what people expect. In March 2020 US breakevens collapsed partly because investors sold inflation-linked bonds to raise cash, not because everyone suddenly expected deflation. Oil prices also have a big effect on shorter breakevens, so a sharp move in crude can push the five-year breakeven around without saying much about long-term views. I'd cross-check with survey measures like the University of Michigan expectations or the New York Fed survey before reading too much into a single week's move in the market measure.