TIPS breakeven inflation rate, defined as the difference between nominal and TIPS yields of comparable maturities, is potentially useful as a real-time measure of market inflation expectations. In this paper, we provide evidence that a fairly large TIPS liquidity premium existed until recently, using a multifactor no-arbitrage term structure model estimated with nominal and TIPS yields, inflation and survey forecasts of interest rates. Ignoring the TIPS liquidity premiums leads to counterintuitive implications for inflation expectations and inflation risk premium, and produces large pricing errors for TIPS. In contrast, models incorporating a TIPS liquidity factor generate much better fit for these variables and reveal a TIPS liquidity premium that was until recently quite large (~1%) but has come down in recent years, consistent with the common perception that TIPS market grew and liquidity conditions improved. Our results indicate that after taking proper account of the liquidity conditions in the TIPS market, the movement in TIPS breakeven inflation rate can provide useful information for identifying real yields, expected inflation and inflation risk premium.

https://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID2422861_code170891.pdf?abstractid=2422861

Tips from TIPS : The Informational Content of Treasury Inflation-Protected Security Prices

This paper develops a model of the term structures of nominal and real interest rates driven by state variables representing the short-term real interest rate, expected inflation, inflation’s central tendency, and four volatility factors that follow GARCH processes. We derive analytical solutions for nominal bond yields, yields on inflation-indexed bonds that have an indexation lag, and the term structure of expected inflation. Unlike prior studies, the model’s parameters are estimated using data on inflation swap rates, as well as nominal yields and survey forecasts of inflation. The volatility state variables fully determine bonds’ time varying risk premia and allow for stochastic volatility and correlation between bond yields, yet they have small effects on the cross section of nominal yields. Allowing for time-varying volatility is particularly important for real interest rate and expected inflation processes, but long-horizon real and inflation risk premia are relatively stable.

/pdf/inflation-expectations-real-rates-and-risk-premia-evidence-2ybciac8mi.pdf

Inflation Expectations, Real Rates, and Risk Premia: Evidence from Inflation Swaps

The difference between nominal and real interest rates (break-even inflation) is often used to gauge the market's inflation expectations-and has become an important tool in monetary policy analysis. However, break-even inflation can move in response to shifts in inflation risk premia and liquidity premia as well as to changes in expected inflation. This paper sheds light on this issue by analyzing the evolution of U.S. break-even inflation from 1997 to mid-2008. Regression results show that survey data on inflation uncertainty and proxies for liquidity premia are important factors.

/pdf/inflation-risk-premia-and-survey-evidence-on-macroeconomic-1dikk862d3.pdf

Inflation Risk Premia and Survey Evidence on Macroeconomic Uncertainty

Treasury Inflation-Protected Securities (TIPS) are frequently thought of as risk-free real bonds. Using no-arbitrage term structure models, we show that TIPS yields exceeded risk-free real yields by as much as 100 basis points when TIPS were first issued and up to 300 basis points during the 2007–2008 financial crisis. This spread predominantly reflects the poorer liquidity of TIPS relative to nominal Treasury securities. Other factors, including the indexation lag and the embedded deflation protection in TIPS, play a much smaller role. Ignoring this spread also significantly distorts the informational content of TIPS break-even inflation, a widely used proxy for expected inflation.

/pdf/tips-from-tips-the-informational-content-of-treasury-55jrmvlrrz.pdf

Tips from TIPS: the informational content of Treasury Inflation-Protected Security prices ⁄

We examine the informational content of TIPS yields from the viewpoint of a general 3-factor no-arbitrage term structure model of inflation and interest rates. Our empirical results indicate that TIPS yields contained a "liquidity premium" that was until recently quite large (~1%). Key features of this premium are difficult to account for in a rational pricing framework, suggesting that TIPS may not have been priced efficiently in its early years. Besides the liquidity premium, a time-varying inflation risk premium complicates the interpretation of the TIPS breakeven inflation rate (the difference between the nominal and TIPS yields). Nonetheless, high-frequency variation in the TIPS breakeven rates is similar to the variation in inflation expectations implied by the model, lending support to the view that TIPS breakeven inflation rates are a useful proxy for inflation expectations.

Tips from TIPS: the informational content of Treasury Inflation-Protected Security prices

In recent years, monetary policymakers have monitored several measures of market expectations of future inflation. One of these measures is based on the yield differential between nominal and inflation indexed Treasury securities. This yield spread is also called the "breakeven inflation rate." An increase in the breakeven rate is sometimes viewed as a sign that market inflation expectations may be on the rise. For example, the FOMC frequently refers to the yield spread as a measure of "inflation compensation" and considers the yield spread an indicator of inflation expectations in policy deliberations.1Accurately inferring market expectations of inflation from yield spreads is difficult. The difficulty lies in the differences in market liquidity conditions between nominal and inflation indexed Treasury securities. This article presents evidence that liquidity differences between nominal and inflation indexed Treasuries have been nontrivial. Consequently, simply attributing changes in yield spreads to changes in market inflation expectations and ignoring the liquidity risk premium could lead to overstated inflation expectations.The first section of the article gives a brief overview of inflation indexed Treasury securities, the components of the yields of both nominal and indexed Treasuries, and their yield spreads. The second section examines the behavior of the yield spreads over the past few years and explains why changes of the liquidity risk premium have likely played an important role in the changes of the yield spreads. This section also provides some estimates of the changes in the liquidity risk premia during the past seven years and argues that ignoring such changes may lead to erroneous inferences of inflation expectations.I. INFLATION INDEXED TREASURY SECURITIES AND COMPONENTS OF THE YIELD SPREADSThis section discusses the main features of inflation indexed Treasury securities, which are commonly referred to as TIPS. Next, it examines the components of the yields of nominal securities and TIPS. Finally, it identifies the conditions needed to obtain useful information about market inflation expectations directly from the yield spreads.TIPS and their marketsThe U.S. Treasury began issuing TIPS in 1997. Initially called Treasury Inflation Protected Securities, their official name was later changed to Treasury Inflation Indexed Securities (TIIS). Market participants have continued to call the instruments TIPS.The first TIPS had a maturity of ten years. Every year since 1997, Treasury has issued additional 10-year TIPS. TIPS with 5-year, 20-year, and 30-year maturities have also been issued intermittently. In December 2005, a total of $329 billion TIPS were outstanding, accounting for about 7.9 percent of the $4.2 trillion in outstanding marketable Treasury securities. Of Treasuries issued with at least two years' maturity, TIPS account for 10.3 percent.2The main advantage of TIPS over conventional nominal securities is that TIPS investors are not exposed to inflation risk.3 The coupon rate of a TIPS is fixed in real terms at auction, and the dollar value of the principal grows with inflation over the life of the TIPS. The real return, which is measured by purchasing power, does not vary with inflation.In contrast, the coupon payments and the principal of a nominal Treasury security are fixed in dollar terms. Thus, the purchasing power, or real return, of a nominal Treasury declines as inflation rises.4Components of nominal Treasury yieldsTo investors, the real rate of return, or real yield, of an investment is important because it measures the result of the investment in terms of purchasing power.5 The yield of a nominal Treasury contains three main components: the real yield, the yield that is equal to the expected rate of average inflation for the remaining life of the Treasury, and the inflation risk premium (which compensates investors for the risk that the actual inflation rate over the life of the Treasury may be higher than expected). …

Liquidity Risk Premia and Breakeven Inflation Rates

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Liquidity Risk Premia and Breakeven Inflation Rates