TIPS Spread

What Is TIPS Spread?

TIPS spread is the difference in the yields between U.S. treasury bonds and Treasury Inflation-Protected Securities (TIPS) and is a useful measure of the market’s expectation of future Consumer Price Index (CPI) inflation.

Understanding TIPS Spread

The TIPS spread compares the yield of the TIPS and the yield of regular U.S. Treasury securities with the same maturity dates. The difference between the two is that the TIPS payments adjust for inflation, while U.S. Treasury payments do not. Normal U.S. Treasury securities do not initially take inflation into account, so the yield must compensate investors for future inflation in addition to the interest rate. Principal, or the face value, of TIPS securities will vary as it is tied to the change in the consumer price index (CPI), which means that the coupon rates will also vary.

This variability of the principal is key as it is linked to the metric, CPI, that measures the level of inflation in the economy. Since inflation is already factored in, the yield for TIPS securities equates to the real interest rate. This means that the difference between this yield and nominal U.S. bond yield, or the TIPS spread, reflects the market forecast for inflation. Since TIPS securities factor in predicted inflation and are backed by the U.S. government, they are considered to be low-risk investments.

It is important to note that the TIPS spread is only a projection of investor's expectations of futures inflation. The reality is that it's impossible to know what the actual future inflation will turn out to be. The TIPS spread has often underestimated inflation levels. However, even with this, the TIPS spread is considered to be a reliable way to predict approximate levels of inflation.

Relevance of TIPS Spread

The TIPS spread is an indication of the market's outlook for inflation. Therefore, the TIPS spread is influential when it comes to investors' expectations about the market economy. If the TIPS spread is wide, this means that investors expect inflation to rise significantly. Similarly, if the TIPS spread is narrow, this reflects investors' expectations that inflation will be stagnant.

For example, if a U.S. Treasury security that matures in ten years has a yield of 5% and a TIPS security with the same maturity date has a yield of 3%, the difference in yield, 2%, is the TIPS spread. This means that inflation is expected to increase by 2% per year over the next ten years. In general, the Federal Reserve tries to keep inflation expectations anchored at around 2%, as inflation rates projected to be too high or too low make it difficult to achieve sustainable real economic growth.