“A market-based estimate of expected inflation can be derived from the differences in the yields for T-bonds and TIPS having comparable maturities” according to Schweser, therefore:
î = (YTM 20y T-bonds) - (YTM 20y TIPS)
From my understanding, TIPS coupons and principals are adjusted upwards in case of inflation. Does this mean that a negative î means inflation, and a positive î means deflation? I don’t see it very clear.
Thanks!
A 20-year T-Bond’s coupon rate is a nominal rate; it includes an inflation premium.
A 20-year TIPS’ coupon rate is a real rate; it doesn’t include an inflation premium. (Inflation is applied to the principal, and, through that mechanism, the coupon amount; it is not applied to the coupon rate.)
Thus, the difference:
20-year T-Bond coupon rate – 20-year TIPS coupon rate
gives you an estimate of the (average) 20-year inflation rate. When it’s positive, expect positive inflation; when it’s negative, expect negative inflation (deflation).
You are correct in that the principal and coupon are adjusted for inflation, but incorrect in your interpretation.
Say the expected inflation is 2%, then investors will require approximately 2% more on YTM of the nominal bond to be indifferent between the nominal bonds and the TIPS (because the nominal bond coupons and facevalue will not be adjusted). There is a premium that the investor requires to invest in the non-inflation protected security (nominal yield bond) and that premium is approximately equal to the expected inflation.
You’re correct: I should have been clearer that the difference is the inflation premium, not (necessarily) the _ expected value of inflation _. However, as you point out, the two are close to each other, so the former is a reasonable estimate (within some (small) margin of error) of the latter.
^ For the record, I was not correcting you. We only happened to respond to the OP’s question at about the same time.