Finance Terms

What Are TIPS? TIPS are U.S. Treasury bonds designed to protect purchasing power. Their principal adjusts with inflation as measured by the Consumer Price Index for All Urban Consumers (CPI-U). Interest is paid on the adjusted principal, so your dollar interest payments rise (or fall) with inflation (or deflation). How TIPS Work Principal indexation: The bond’s principal is multiplied by an Index Ratio derived from CPI-U. If CPI rises 3% over a period, principal rises ~3%. If prices fall, principal can decrease. Fixed coupon rate, variable payments: The coupon rate is set at issuance (e.g., 1%). Your cash interest = coupon rate × inflation-adjusted principal , so the dollar amount changes with CPI. Maturities: Typically 5, 10, or 30 years. At maturity you receive the greater of the adjusted principal or the original principal (i.e., deflation floor). Quick Example Invest $1,000 in a new 10-year TIPS with a 1.0% coupon. If CPI pus...

Break-Even Inflation Rate The break-even inflation rate is a market-based measure of expected inflation. It is calculated by looking at the difference in yield between a regular government bond (also called a nominal bond) and an inflation-protected bond, such as a Treasury Inflation-Protected Security (TIPS) , with the same maturity. This rate tells investors what the market expects the average inflation rate to be over a certain period. If actual inflation ends up being higher than the break-even rate, TIPS would perform better than nominal bonds. If inflation is lower, the regular bond would likely give better returns. Here’s a simple example: Suppose a 5-year U.S. Treasury note offers a 4.0% yield, and a 5-year TIPS offers a 1.5% yield. The difference, 2.5%, is the break-even inflation rate. This means investors expect inflation to average around 2.5% per year over the next five years. Investors use this rate to guide decisions. If they believe inflation will be higher th...

Currency Carry Trade A currency carry trade is a strategy where investors borrow money in a country with low interest rates and invest it in a country with higher interest rates. The goal is to earn a profit from the difference between the two rates. For example, imagine an investor borrows Japanese yen, where interest rates are very low, and converts it into U.S. dollars to invest in U.S. bonds that pay higher interest. If everything goes well, the investor earns the higher interest from U.S. while paying less on the borrowed yen. But this strategy comes with risk. The biggest one is exchange rate movement. If the U.S. dollar falls in value compared to the yen, the gains from the interest rate difference could be wiped out, or worse, the investor could lose money. Currency values can change due to economic news, political events, or changes in central bank policies. Carry trades are common in global markets, especially when interest rates across countries differ. Central ba...

Sahm Rule The Sahm rule is a tool used to identify when the U.S. economy has likely entered a recession. It is based on changes in the unemployment rate. According to this rule, a recession is signaled when the three-month average unemployment rate rises by at least 0.5 percentage points above its lowest point over the past 12 months. This method was developed by economist Claudia Sahm and offers a faster, data-driven way to detect recessions. Traditional methods, like official declarations from the National Bureau of Economic Research (NBER), take months to confirm a recession. The Sahm rule, on the other hand, uses simple and timely labor market data to give an early signal. For example, during the COVID-19 pandemic in early 2020, the unemployment rate jumped sharply. The Sahm rule quickly indicated that the economy was in recession, well before official announcements were made. This made it a valuable indicator for policymakers and economists who needed to act quickly. It...