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I read a article where the author used the difference the between yields of 5 year Tips and 2 year Tips as a proxy of the inflation expectation. Could anyone explain me what is the logic behind this approach. Thanks.

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  • $\begingroup$ You can infer how an inflation would evolve from these numbers. For example when yields on 5Y TIPS is lower than for 2Y one, market participants expect inflation presure easing, or in other words lower inflation on 5Y horizon than on 2Y one. $\endgroup$ Apr 4, 2020 at 22:12
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    $\begingroup$ Thanks Martin. But as I suppose, TIP is free of inflation risk, so its yield doesn't contain any component related to inflation. So how could it give us any inflation expectation? $\endgroup$
    – Lopo
    Apr 5, 2020 at 1:56
  • $\begingroup$ Sorry, my previous answer was not clear, or maybe misleading. Try again: Yield on TIPS is a equal yield on normal Treasury bond minus expected inflation. So yield on Treasury minus yield on TIPS is expected inflation on time horizon given by respective maturity. So having Treasury and TIPS yield curve allow you to infer expected inflation along the curve. Hence you can see how inflation expectations evolve. Maybe this was the author mentioned. But as you said, yield on TIPS is real one. $\endgroup$ Apr 5, 2020 at 7:09
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    $\begingroup$ Thanks Martin. You are correct. Given the flattened treasure yield curve, the inflation expectation from the second year to the fifth year can just be estimated by the difference between Tip 5 and Tpis 2. $\endgroup$
    – Lopo
    Apr 5, 2020 at 12:49

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In short, the author is using the difference in yields between 5 year Tips and 2 year Tips as a proxy for inflation expectations. The logic behind this approach is that, in general, longer-term bonds will have higher yields than shorter-term bonds. This is because investors require a higher return in order to compensate for the greater risk associated with longer-term investments. However, if inflation expectations are high, then investors will demand an even higher return on their investment in order to protect the purchasing power of their money. As a result, the yield on longer-term bonds will increase at a faster rate than the yield on shorter-term bonds, resulting in a widening of the yield spread.

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