Deflation or Inflation ETFs? Why The Bond and Commodity Markets Are Forward-Looking

Everyone points to the November 2008 lows as a critical "bottoming" area for stocks. For the S&P 500 to build a base, it has been said, it must not establish new closing lows below 750.

Keep in mind, though, virtually all assets and sub-classes free-fell in November. Corporate bonds, inflation protected bonds, high-yield bonds, preferrred stock, U.S. common stock, foreign stock, as well as scores of commodities, all hit 52-week lows November 20.

Some of these asset types have continued to fall, setting new lows. Deflation fears and dollar devaluation took the wind out of oil and base metals. Meanwhile, stocks have been in a wide trading range since November, with the S&P moving between 750 and 940. (If you exclude one day, we're really talking about 800 and 940.)

With trillions of taxpayer dollars being spent on stimulus, bailout, confidence restoration and "breaking-the-deflation-death-spiral," are the markets already worried about the repercussions? The rise in precious metals and treasury-inflation protected securities suggests that the markets might be thinking way ahead.

Consider the once-boring area of the iShares Treasury Inflation Protected TIPS (TIP). It seemed pretty hard to get excited about a 2% or 3% yield when things were moving along smoothly... inflation be damned.

Then the commodity bubble burst, followed by the credit calamity. Deflationary pressures sent TIP form 110 to 90 in a matter of months. Nevertheless, in a few more months, the iShares Treasury Inflation Protected TIPS (TIP) was back above 100.

Perhaps the yield itself was enough to get buyers interested. It's as high as 6.25% today- pretty hard to beat for income investors.

Yet there's little reason to doubt that 0% overnight lending rates and the massive amounts of Fed liquidity injections aren't persuading some people to use TIP as an investment in the future; that is, palpable inflation may just be a matter of time.

In addition to a desirable 6.25% yield right now, there's another sign of strong demand for the iShares Treasury Inflation Protected TIPS (TIP). It's one of a select group of ETFs that currently push the 200-day moving average AND have risen close to 10% in 10 weeks.

There are those that gold and silver also protect against inflation. If the markets were living in the present, rather than acting in a forward-looking manner, one might expect to see the Powershares Precious Metals Fund (DBP) struggling alongside equities.

Instead, the historical inflation-fighting metals have accomplished what few ETFs have done since the November lows; specifically, DBP has pushed above a long-term trendline of 200 days AND racked up more than 10% gains... much like TIP.

Sure, we can talk about fear of currency failure favoring precious metals. Or we can point to an outstanding 6.25% yield as sparking interest in inflation-protected treasuries. Nevertheless, I am equally inclined to believe that these trends are a result of forward-looking plays on the eventual return of inflation.

Disclosure Statement: ETF Expert is a web log ("blog") that makes the world of ETFs easier to understand. Pacific Park Financial, Inc., a Registered Investment Advisor with the SEC, may hold positions in the ETFs, mutual funds and/or index funds mentioned above. Investors who are interested in money management services may visit the Pacific Park Financial, Inc. web site.

Comments

[User 319940]

Well, I have to wonder how well informed this character is.

He mentions, several times, the 6.25 % yield on TIP. Not so, currently the fund is paying no distributions. This will continue until the CPI again turns up.

I am heavy in TIP but the current yield is not the reason

2009 Feb 11 09:35 AM

[oldman]

Also, how can Tips yield more than the bonds it holds? There is no leverage.

2009 Feb 11 11:19 AM

[oldman]

Here is fundamental data from ishares website.


Fundamentals Fund as of 2/9/2009 Index as of 1/30/2009
Number of Holdings 28 26
The mean of the remaining term to maturity of the underlying bonds in a portfolio.Weighted Average Maturity 9.14 yr 9.09 yr
The mean of the coupon rate of the underlying bonds in a portfolio.Weighted Average Coupon 2.27% 2.22%
A measure of the responsiveness of a bond or portfolio's price to changes in interest rates. Effective Duration takes into account the possible changes in expected bond cash flows due to interest rate changes.Effective Duration 5.65 5.63
Yield Fund as of 2/9/2009 Index as of 1/30/2009
The annual yield an investor would receive if the most recent fund distribution stayed the same going forward. The yield represents a single distribution from the fund and does not represent the total return of the fund. The yield is calculated by annualizing the most recent distribution and dividing by the fund NAV from the as-of date.Distribution Yield 0.00% N/A
A standard yield calculation developed by the Securities and Exchange Commission that allows for fairer comparisons among bond funds. It is based on the most recent 30-day period. This yield figure reflects the interest earned during the period after deducting the fund's expenses for the period.30-Day SEC Yield 2.33% N/A
The average YTM is the interest rate that will make the present value of the cash flows from a bond equal to its market price plus accrued interest. The average yield to maturity considers not only the coupon income, but any capital gain or loss that the investor will realize by holding the bonds to maturity. It also considers the reinvestment of the coupons.Average Yield to Maturity 2.90% 3.02%
Real yield is the yield before adjusting for inflation. The realized yield will be a combination of the real yield and an inflation adjustment based on the change in Consumer Price Index.Real Yield 1.78% N/A

2009 Feb 11 11:28 AM

[Gary Gordon]

The primary intent of the feature is to talk about forward-looking investments. It appears that smarter money anticipates significant inflation.

Keep in mind, there are many ways to present yield for a particular ETF. One might argue that the last month's $0 payment means that $0 will continue throughout 2009 such that the annual yield is 0%. Another might argue that the 2.33% SEC 30-day yield which accounts for payments in the prior 30 days is the most accurate.

Yet the simple fact remains, the ANNUAL yield is 6.25% based on what was paid throughout seemingly erratic payment dates in 2008. Equally important, many investors believe that inflation will return... and if so... it is likely that the ANNUAL yield will approximate this percentage. One can see the top 10 holdings as of 12/31/2008 at this PDF file to see how a 6% yield may be anticipated.
us.ishares.com/content...

2009 Feb 11 12:03 PM

[Fabien Hug]

I have problems to believe in the inflation theory. Pressure on wages is going to be huge in the future. It was already huge before the recession.
Wage increase is the ONLY inflationary event that seems to worry our masters, hence, I don't see official inflation take off before a long time.
On the other hand, what I don't like with TIPS is that they are indexed by the same people that issue them. The deal is flawed even if it may offer a better return relative to other investments if inflation increases. There should be something better than that on the market to protect oneself against inflation. The problem is I don't know which.

2009 Feb 11 12:46 PM