DEFINITION of TIPS Spread
The TIPS spread compares the yield of the Treasury Inflation Protection Securities (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.
BREAKING DOWN TIPS Spread
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. Coupons and principal rates of TIPS securities, however, change based on the consumer price index (CPI), which provides statistics that give insight into the potential direction of inflation. Since inflation is already factored in, the yield for TIPS securities includes only the rate of interest, which is fixed. This means that the difference between these two yields, or the TIPS spread, reflects the forecasted inflation.
Since TIPS securities factor in predicted inflation and are backed by the government, they are considered to be low-risk investments.
Why Pay Attention to the TIPS Spread?
The TIPS spread is an indication of the market's outlook for inflation. Therefore, the TIPS spread has a high influence on investors' expectations and opinions of the market economy. If the TIPS spread is wide, this means that investors have high hopes for the security, and inflation is expected to rise significantly. Similarly, if the spread is narrow, investors do not have high expectations, and inflation is expected to stay somewhat 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 to 2.5%; inflation rates projected to be too high or too low reflect poorly on the economy and make it difficult to emerge from a recession.
How Effective is the TIPS Spread in Predicting Inflation?
The TIPS spread is only a projection of inflation, as it's impossible to know what turns the market will take in the future. In the past 20 years, the TIPS spread has underestimated inflation levels about two-thirds of the time. Overall, however, the TIPS spread is considered to be a reliable way to predict approximate levels of inflation.