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The Relationship Between Oil Prices and Breakeven Inflation Rates

Robin L. Lumsdaine

American University - Department of Finance and Real Estate; National Bureau of Economic Research (NBER)

December 29, 2009

This paper explores the role of oil prices in the inflation-linked bond markets. Early proponents of inflation-linked bonds highlighted their role in protecting against future inflation, portfolio diversification, asset-liability matching, and use as a commitment tool for monetary policy in keeping inflation contained. From an investment perspective, real return assets should be attractive in prolonged periods of high inflation and unattractive in periods of low inflation resulting in increased demand for real return assets as inflation expectations grow and decreased demand as such expectations diminish. The late 1990s and early 2000s saw an expansion in the inflation-linked bond markets, with more sovereign issuers, increased issuance size and a wider range of maturities; this tremendous growth in turn fueled greater interest and participation in these markets. After a prolonged period of low and stable inflation, the rise in oil prices that began in 2003/4 coincided with the rapid expansion of the inflation-linked bond markets and the start of the Federal Reserve’s tightening cycle. In addition, the widening of the yield spread between nominal and inflation-linked bonds, or “breakeven”, during this time was seen as an indication that inflation expectations were on the rise. Much of the runup in breakevens was attributed to the observed increases in oil prices. Yet despite similar trends, over most of the sample period, breakevens and oil have not moved one-for-one. Recently, however, the decline in oil prices has coincided with a dramatic decline in breakevens and unprecedented Fed easing. The results demonstrate that the coincidence of breakeven and oil price fluctuations is a relatively recent phenomenon, unique to the US market, and mainly associated with the front end of the breakeven curve.

Number of Pages in PDF File: 20

Keywords: breakeven inflation, oil prices, TIPS, inflation-linked bonds, inflation-indexed, inflation expectations

JEL Classification: E44, G15, Q43

working papers series

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Date posted: December 30, 2009  

Suggested Citation

Lumsdaine, Robin L., The Relationship Between Oil Prices and Breakeven Inflation Rates (December 29, 2009). Available at SSRN: http://ssrn.com/abstract=1529487 or http://dx.doi.org/10.2139/ssrn.1529487

Contact Information

Robin L. Lumsdaine (Contact Author)
American University - Department of Finance and Real Estate ( email )
Kogod School of Business
4400 Massachusetts Ave., N.W.
Washington, DC 20016-8044
United States
National Bureau of Economic Research (NBER) ( email )
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
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