breakeven-inflation-and-real-yields — yield duration and convexity

The Treasury market constantly broadcasts an inflation forecast. The 10-year breakeven inflation rate currently sits at 2.22%, while the 10-year TIPS real yield is 1.45% (Federal Reserve, December 2025). These numbers tell you what bond investors are collectively betting about price levels over the next decade. The practical antidote to guessing about inflation: learn to read what's already priced in—and when that signal gets distorted.

What Breakeven Inflation Actually Measures

Breakeven inflation is the difference between nominal Treasury yields and TIPS real yields at the same maturity. It represents the average annual inflation rate that would make you indifferent between holding a nominal Treasury and an inflation-protected Treasury.

The formula:

Breakeven Inflation = Nominal Treasury Yield - TIPS Real Yield

Current example (December 2025):

10-year nominal Treasury yield: 3.67% 10-year TIPS real yield: 1.45% 10-year breakeven inflation: 3.67% - 1.45% = 2.22%

The point is: If actual inflation averages exactly 2.22% annually over the next decade, you earn the same return from either bond. If inflation runs higher, TIPS win. If inflation runs lower, nominals win.

Causal chain:

Nominal yield (total compensation) → Real yield (after-inflation return) + Breakeven inflation (market's inflation bet)

Why Real Yields Matter (The Purchasing Power Test)

Real yields tell you what you actually earn after inflation eats into your returns. A 1.45% real yield on 10-year TIPS means your purchasing power grows 1.45% annually—guaranteed by Treasury inflation adjustments.

The contrast:

Nominal 10-year Treasury at 3.67%: Your nominal return is fixed, but real return depends on what inflation does
TIPS at 1.45% real: Your purchasing power growth is locked in regardless of inflation outcomes

Why this matters: In late 2021, 10-year TIPS real yields were negative (around -1.0%). Buyers were locking in guaranteed purchasing power losses for a decade. By late 2022, real yields had swung to +1.5%—a 250 bps shift in actual after-inflation compensation.

The durable lesson: Negative real yields signal extreme conditions (usually aggressive Fed policy or flight-to-safety demand). Positive real yields above 1.0% offer meaningful after-inflation compensation.

Reading the Components (A Practical Walkthrough)

You check Treasury markets and see these December 2025 quotes:

5-year maturity:

Nominal Treasury yield: 3.45%
TIPS real yield: 1.25%
Implied breakeven: 2.20%

10-year maturity:

Nominal Treasury yield: 3.67%
TIPS real yield: 1.45%
Implied breakeven: 2.22%

30-year maturity:

Nominal Treasury yield: 4.80%
TIPS real yield: 2.10% (estimated)
Implied breakeven: 2.70%

What this tells you:

The market expects inflation to average roughly 2.2% over the next 5-10 years (close to the Fed's 2% target), but edges higher for 30-year horizons. That upward slope in longer-term breakevens suggests some concern about long-run inflation risks—or simply a term premium for bearing more uncertainty.

When Breakevens Lie (The Liquidity Distortion)

Here's the problem: TIPS are less liquid than nominal Treasuries. Fewer investors trade them, bid-ask spreads are wider, and during stress periods, this illiquidity gets priced in as an extra discount.

The distortion mechanics (Gurkaynak, Sack, and Wright, 2008):

TIPS liquidity discount vs nominals can add 20-50 bps to TIPS yields
This makes breakevens look artificially low during stress
Off-the-run matching (comparing similar-maturity off-the-run issues) reduces but doesn't eliminate the bias

Example: March 2020 COVID stress

During March 9-18, 2020, Treasury markets experienced severe dislocations. Foreign institutions sold nearly $300 billion of Treasuries in a liquidity scramble (New York Fed, 2020). TIPS sold off even harder than nominals because panicked sellers prioritized liquidity over inflation protection.

Result: Breakeven inflation collapsed not because inflation expectations collapsed, but because TIPS became temporarily harder to sell. The signal became noise.

The test: Are breakevens moving because inflation views changed, or because TIPS liquidity deteriorated? Check credit spreads and VIX—if stress indicators spike alongside falling breakevens, suspect liquidity distortion.

The Inflation Risk Premium (What's Not Visible)

Breakeven inflation isn't a pure inflation forecast. It contains an embedded inflation risk premium—compensation investors demand for bearing inflation uncertainty.

Decomposition:

Breakeven Inflation = Expected Inflation + Inflation Risk Premium - Liquidity Premium

The inflation risk premium can run +20 to +50 bps in normal markets (investors want extra compensation for inflation surprises). But during deflation scares, it can flip negative.

Why this matters: A breakeven of 2.22% might mean expected inflation of 2.0% plus a 22 bps risk premium. Or it might mean expected inflation of 2.4% minus a 18 bps liquidity premium. You can't directly observe the split.

The practical point: Treat breakevens as market indicators with noise, not as precise forecasts. Compare to survey-based expectations (like the University of Michigan or the Fed's Survey of Professional Forecasters) to triangulate.

Historical Context: When Breakevens Signaled Correctly

2021-2022 Inflation Surge:

In early 2021, 10-year breakevens rose from around 2.0% to 2.5% as stimulus spending and supply chains strained. By March 2022, breakevens touched 3.0%. Actual CPI inflation subsequently ran 7-9% in 2022—well above even the elevated breakevens.

Interpretation: Breakevens underestimated the inflation surge, but they moved in the right direction earlier than Fed policy acknowledged the problem. Investors who watched breakevens climb had an early warning signal.

2008 Financial Crisis:

In late 2008, 10-year breakevens collapsed below 1.0% as deflation fears gripped markets. TIPS briefly priced in near-zero inflation for a decade. Actual inflation subsequently averaged around 1.5-2.0% over the following decade—above what breakevens implied.

Interpretation: The crisis-era collapse reflected both genuine deflation fears and severe liquidity distortions. Buying TIPS at negative breakevens (effectively betting that inflation would exceed near-zero) proved profitable.

Detection Signals: You're Likely Misreading Breakevens If...

You treat the number as a precise forecast rather than a market indicator with embedded premia
You check breakevens during stress periods without accounting for liquidity distortions
You compare 5-year breakevens to 10-year breakevens without recognizing they measure different horizons (not always an apples-to-apples comparison)
You use breakevens alone without cross-referencing survey expectations or Fed projections
You assume breakevens predict near-term inflation (they reflect average expectations over the full maturity, not next year's CPI)

TIPS vs. Nominals: The Decision Framework

Favor TIPS when:

Real yields exceed 1.5% (strong after-inflation compensation)
Breakevens look artificially low (liquidity stress + no genuine deflation risk)
You need guaranteed purchasing power for liability matching
You believe inflation will exceed market expectations

Favor nominals when:

Breakevens look elevated relative to credible inflation forecasts
You expect disinflation or deflation
You prioritize liquidity and simpler tax treatment (TIPS have phantom income issues)
You believe the market is overpricing inflation risk

The nuance: Most investors don't need to choose one or the other. A diversified bond allocation can include both, letting the market sort out which wins over your holding period.

Checklist: Reading Inflation Signals

Essential (high ROI)

Calculate current breakevens at 5, 10, and 30-year maturities (subtract TIPS real yield from nominal yield)
Compare to Fed's target (2%)—breakevens significantly above or below signal market disagreement with policy
Check for liquidity stress before interpreting falling breakevens as changed inflation views
Compare to surveys (University of Michigan, SPF) to triangulate expectations

High-impact refinements

Monitor breakeven changes over weeks, not days (short-term noise dominates)
Watch the 5y5y forward breakeven (expected inflation 5-10 years from now)—Fed officials cite this as a measure of long-term inflation anchoring
Track real yield levels separately from breakevens—negative real yields are historically unusual

Your Next Step

Pull up current Treasury and TIPS yields from the Federal Reserve H.15 release or TreasuryDirect:

Calculate the 10-year breakeven (nominal 10-year minus TIPS 10-year real yield)
Compare to the Fed's 2% target—is the market pricing inflation above or below target?
Check the 10-year real yield—positive or negative? Above or below 1%?

Interpretation:

Breakeven above 2.5%: Market sees above-target inflation risk
Breakeven 1.8%-2.2%: Roughly aligned with Fed's target
Breakeven below 1.5%: Deflation concerns or liquidity distortions—investigate further

Action: If you hold significant nominal bond exposure and breakevens rise above 2.5%, consider whether adding TIPS exposure makes sense as inflation insurance.

Related: Nominal Yield, Current Yield, and Yield-to-Maturity | Spot Curves vs Par Curves | Understanding Treasury Yield Curve Shapes

Source: Federal Reserve, H.15 Selected Interest Rates (December 2025). Gurkaynak, Sack, and Wright, The TIPS Yield Curve and Inflation Compensation, American Economic Journal: Macroeconomics (2008). New York Fed, Treasury Market Liquidity during the COVID-19 Crisis (2020). Hartford Funds, Duration of the Bloomberg US Aggregate Bond Index (2025).

Breakeven Inflation and Real Yields