Introduction
Israel’s government bond market provides a direct way to compare nominal and inflation-linked returns. CPI-indexed bonds protect investors against changes in the consumer price index according to the terms of the security, while unindexed bonds pay nominal cash flows. The yield difference between the two is therefore a key input into market-based measures of expected inflation.
This does not make the spread a perfect forecast. The Bank of Israel explicitly notes that market-derived inflation expectations include an inflation-risk premium and can be affected by liquidity, taxation and other differences between indexed and unindexed securities. Even so, the relationship remains one of the most valuable signals in the domestic fixed-income market.
Nominal Yield, Real Yield and Breakeven
A nominal government yield can be thought of as compensation for real interest rates, expected inflation and risk premiums. An indexed bond removes much of the realised inflation uncertainty from the investor’s return, so its yield provides a closer approximation to the real component. The difference between the two curves is commonly called breakeven inflation.
If a five-year nominal bond yields materially more than a five-year indexed bond, the gap reflects the inflation compensation required by investors over that horizon. If realised inflation averages more than the breakeven level, the indexed bond may outperform on that dimension; if inflation is lower, the nominal bond may prove more attractive, ignoring other differences.
What Moves Inflation Compensation
Breakeven inflation can rise because investors expect higher future inflation, because they demand more compensation for uncertainty, or because technical demand changes in one segment of the market. It can fall for the opposite reasons. The signal is therefore strongest when it moves alongside other measures such as professional forecasts, inflation swaps or survey expectations.
Currency movements are particularly relevant in Israel because a weaker shekel can raise imported inflation pressure. Energy prices, wage growth, fiscal policy and global goods prices also matter. The market continuously combines these inputs into nominal and real yields.
Real Rates and Financial Conditions
Real yields are important because they describe the cost of capital after adjusting for inflation. Rising real rates can tighten financial conditions even if headline inflation expectations are stable, while falling real rates can support asset valuations and borrowing demand.
For the Bank of Israel, the real-rate environment helps determine how restrictive monetary policy is relative to the economy. For investors, changes in the real curve can be more informative than changes in nominal yields when inflation expectations are moving at the same time.
The Curve Across Horizons
Inflation expectations are not constant across maturities. Near-term breakevens may respond strongly to current energy prices or exchange-rate moves, while longer-term measures reflect whether investors believe the central bank will ultimately maintain price stability. A widening gap between short- and long-term inflation compensation can therefore reveal whether markets see a temporary shock or a more persistent regime shift.
This term structure is especially valuable during volatile periods. If short-term inflation expectations jump while long-term measures remain anchored, the market may be pricing a transitory shock. If long-term compensation rises as well, confidence in the medium-term inflation anchor may be weakening.
What Investors Should Watch
Inflation analysis should compare breakevens with independent measures rather than treating them as self-contained forecasts. Professional expectations, inflation swaps where available, realised CPI trends and the exchange rate can help determine whether a move in breakevens reflects a genuine macro shift or a technical change in bond-market liquidity.
The real curve deserves equal attention. A rise in real yields can tighten financing conditions even when inflation expectations fall, while declining real yields can ease conditions despite high nominal rates. For asset valuation, the real discount rate is often the more important variable, particularly for long-duration equities and infrastructure assets.
Conclusion
Israel’s indexed and unindexed government bonds provide a rich framework for separating nominal yields into real-rate and inflation components. The resulting breakeven measures are imperfect but highly informative when interpreted with appropriate caution.
For fixed-income analysis, the key is not to treat one breakeven number as a forecast. The more useful approach is to examine how real yields, nominal yields and inflation compensation move across maturities and how those changes relate to the shekel, monetary policy and fiscal conditions.