Breakeven Inflation, Earnings Yields, and Long-Run Models
Summary
The document asks how to infer discounted inflation and earnings growth by comparing nominal bond yields with inflation-linked bond yields or equity earnings yields. It identifies the nominal yield minus the inflation-linked yield as breakeven inflation, and notes that comparing earnings yield with interest rates is commonly associated with the Fed model. It also relates comparisons of earnings yield and credit spreads to similar valuation approaches.
The answer cautions that these yield gaps are not necessarily standalone measures with universally accepted names. To study their long-run relationships with asset returns, it suggests error-correction methods or a VAR in levels, which can represent long-run trends and mean reversion. Treating simple yield differences as explanatory variables effectively imposes restrictions on regression coefficients. A second answer points to Fisher’s equation, but the document provides no derivation, data, or empirical results, so it does not establish how well any of these approaches predict returns.
Key ideas
- The difference between nominal Treasury yields and inflation-linked yields is commonly called breakeven inflation.
- Comparing earnings yields with nominal rates is associated with the Fed model.
- Error-correction methods and VARs in levels can represent long-run relationships and mean reversion.
- Using yield differences directly in a regression imposes constraints on its coefficients.
- The document names Fisher’s equation as a relevant concept but does not explain its application.
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Full text
# How to calculate discounted inflation and growth? # How to calculate discounted inflation and growth? Given the nominal bond yield and the inflation index bond yield (earning yield), how would one calculate the discounted inflation rate (discounted earning growth rates)? These two factor seems to explain a lot of the return of asset classes which I like to explore more. Edit: From an article that I couldn't find anymore, here is a a simple chart that shows the discounted growth rate index. A small quote I saved "...by comparing nominal Treasury bond yields with inflation indexed bond yields, we can see the discounted inflation rates...by comparing nominal bond yield to earnings yield, we can calculate the discounted earnings growth rate; by looking at credit spreads, we can calculate the discounted rate of credit problem" ## Answer by John (score 2, accepted) https://quant.stackexchange.com/a/4678 The problem is more that the article you read uses language that is not consistent with the way most people in finance talk. People typically call the difference between the nominal Treasury yield and an inflation-linked bond the breakeven inflation rate. When people look at the difference between the earnings yield and the nominal interest rate, they might say they are drawing conclusions based on the fed model. I don't think this difference necessarily deserves its own name, but people are familiar with the term fed model. Similarly when comparing the earnings yield to credit spreads, this is also similar to a different type of fed model, see the paper by Asness called "Fight the Fed Model." In general, these approaches are about identifying long-run relationships and investigating how they impact other variables (like stock or bond returns). The more general approach is to apply the Error Correction methodology (or VAR in levels). This approach will extract the long-run trends and account for mean-reversion, whereas using these differences is like imposing constraints on the regression coefficients. ## Answer by Fredrik E (score 0) https://quant.stackexchange.com/a/4698 Fisher's equation is what you need. http://en.wikipedia.org/wiki/Fisher_equation
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