Final answer:
To estimate the expected annual rate of inflation over the next 8 years, analyze the yield to maturity (YTM) difference between TIPS and standard Treasury bonds. The market's inflation expectations are inferred from the yield differential, as TIPS offer lower yields due to inflation compensation. With a TIPS yield at 2% and Treasury yield at 4.25%, the expected inflation rate is -1.25%, indicating deflation.
Step-by-step explanation:
To gauge the expected annual rate of inflation over the next 8 years, we need to analyze the difference in yield to maturity (YTM) between a Treasury Inflation-Protected Security (TIPS) and a conventional US Treasury note. Typically, TIPS offer a lower YTM because they compensate for inflation over the tenure of the bond. If the TIPS bond with 8 years to maturity has a YTM of 2%, and a similar maturity regular Treasury bond is yielding a higher rate of 4.25%, the market expectation for inflation can be inferred from the difference.
In this context, it is not the interest or coupon rate that is of importance, but rather the yield that reflects the total return on the bond investment, including both interest payments and capital gains. In fact, when interest rates rise, the price of existing bonds fall to increase the yield and vice versa.
Given the provided YTMs, and if the expected annual rate of inflation is -1.25%, this implies that the TIPS is providing a real return—the return in excess of inflation—of 2%, while the standard Treasury note is offering a nominal YTM of 4.25%. The differential between these two rates can be viewed as the market's expected rate of inflation.