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TIPS, Inflation Expectations and the Financial Crisis

  • Thorsten Lehnert

    ()

    (Luxembourg School of Finance, University of Luxembourg)

  • Aleksandar Andonov

    (Limburg Institute of Financial Economics, Maastricht University)

  • Florian Bardong

    ()

    (Fixed Income Research, Barclays Global Investors, London)

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    Previous research indicates that the US market for inflation-linked bonds is not efficient and that market inefficiencies can be exploited by informed traders who include survey estimations or inflation model forecasts in trades on break-even inflation. Results from this extended research over a time-period in which the TIPS market matured and increased in depth, while the volatility of real yields and inflation increased, confirm that TIPS market inefficiency was not temporary but persisted over the entire time period between 1997 and 2009. Using estimations generated by the Survey of Professional Forecasters or forecasts based on the Kothari and Shanken (2004) inflation model to construct a break-even trading strategy leads to excess returns over a static buy-and-hold strategy. These excess returns remain substantial even after accounting for trading costs. Furthermore, TIPS returns still include a substantial liquidity premium, which increased during the financial crisis.

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    Paper provided by Luxembourg School of Finance, University of Luxembourg in its series LSF Research Working Paper Series with number 09-09.

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    Date of creation: 2009
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    Handle: RePEc:crf:wpaper:09-09
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    1. Fama, Eugene F, 1975. "Short-Term Interest Rates as Predictors of Inflation," American Economic Review, American Economic Association, vol. 65(3), pages 269-82, June.
    2. Florian Bardong & Thorsten Lehnert, 2008. "TIPS and inflation expectations," Applied Economics Letters, Taylor & Francis Journals, vol. 15(7), pages 513-517.
    3. Jeffrey M. Wrase, 1997. "Inflation-indexed bonds: how do they work?," Business Review, Federal Reserve Bank of Philadelphia, issue Jul, pages 3-16.
    4. Giordani, Paolo & Soderlind, Paul, 2003. "Inflation forecast uncertainty," European Economic Review, Elsevier, vol. 47(6), pages 1037-1059, December.
    5. John Y. Campbell & Robert J. Shiller, 1996. "A Scorecard for Indexed Government Debt," NBER Working Papers 5587, National Bureau of Economic Research, Inc.
    6. Nelson, Charles R & Schwert, G William, 1977. "Short-Term Interest Rates as Predictors of Inflation: On Testing the Hypothesis That the Real Rate of Interest is Constant," American Economic Review, American Economic Association, vol. 67(3), pages 478-86, June.
    7. Refet S. Gürkaynak & Brian Sack & Jonathan H. Wright, 2008. "The TIPS yield curve and inflation compensation," Finance and Economics Discussion Series 2008-05, Board of Governors of the Federal Reserve System (U.S.).
    8. Brian Sack, 2000. "Deriving inflation expectations from nominal and inflation-indexed Treasury yields," Finance and Economics Discussion Series 2000-33, Board of Governors of the Federal Reserve System (U.S.).
    9. Mark M. Spiegel, 1998. "Central bank independence and inflation expectations: evidence from British index-linked gilts," Economic Review, Federal Reserve Bank of San Francisco, pages 3-14.
    10. Charles T. Carlstrom & Timothy S. Fuerst, 2004. "Expected inflation and TIPS," Economic Commentary, Federal Reserve Bank of Cleveland, issue Nov.
    11. Fama, Eugene F. & French, Kenneth R., 1989. "Business conditions and expected returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 25(1), pages 23-49, November.
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