Inflation Bogey

In such an environment, one expects deflation to be king and inflation just a wimp of a bogey.

Not so. Treasury Inflation Protected Securities (TIP), and other inflation-linked securities around the world, are in demand. In the recent TIPS auction, the US government sold $6 billion in TIPS and the yield, at 1.589%, was nearly 2% higher than expected by traders polled by Bloomberg.

The difference between rates on 10-year notes and Treasury Inflation Protected Securities, known as TIPS, which reflects the outlook among traders for consumer prices, widened to 1.35 percentage points from near zero at the end of 2008. It has averaged 2.26 percentage points for the past five years.

We can see the demand for TIPS in the following graph of the TIPS ETF:

Notice the sharp rise in mid-March just as soon as the bond market sensed that the stock market might be starting to rally. A hunter out in a dark forest shoots as soon as he thinks he heard a growl.

But is the inflation growl for real?

While we have to be on the alert, and the data is hazy, I don’t think inflation will be a big threat any time soon. The money pumped into the system is still going around at a sluggish pace. The volume of money created has so far been well under the values lost in real estate and stock markets. Velocity of money is likely to remain low so long as the banking system is in crisis (is insolvent?).

Further, the de-leveraging which is taking place has lowered demand for goods and services across the world. Even though supply is contracting as well, there is still an output gap to be closed. Rising unemployment and falling asset prices conspire to keep demand low. Significant inflation is unlikely as long as the output gap persists.

Although the P/E ratio of a capitalization weighted S&P index has been calculated to be around 10 (a voluble “buy”, if it was a prospective P/E estimate and E was after all items, see Prof Siegel's interesting article), we still have to see where are going to land. I feel they still have further down to go since we have only just began to see the effects on the real economy taking hold. A good indicator of better times would be a drop in bankruptcy rates and bond defaults.

So Why the Blip in TIPS?

I think the market is factoring in the possibility of runaway inflation. Why so, in spite of the bad news?

The smart bond market does not believe that authorities around the world will have the political will power to eventually jack up interest rates as required and tighten monetary policy once the huge liquidity starts fueling demand.

They would have had to put up with months or years of high unemployment, election time would be approaching in the States, low interest rates and cheap money would by then be taken for granted, and governments would have the biggest incentive of all: mountains of public debt to inflate away! Stomach for self-induced pain? About nil.

I don’t think it is imminent but the market seems to think it is and so we are holding these investments in the ETF Newsletter, just in case.

DISCLOSURE: I AM LONG: DBC, XLP, XLB and WFC bonds (no stocks). NO POSITION: WFC, IOO, TIP.

Comments

[schmaboo:]

Mr. Azzopardi has made two incorrect statements. Firstly, when
the perceived value of assets fall, the supply of money does not.
There is a buyer and seller for every trade. Secondly, the 70s
are proof that you can have high unemployment and high inflation
at the same time. He does correctly state that the tape tells the truth
and the conclusions he draws are likely as well. Inflation, now runningat 5.5 per cent per year will accelerate, and will become gigantic ina very short time, whether or not the "velocity" of money grows. This will be an inflationary depression.

Apr 12 01:03 PM

[Prudent Man...:]

As one of our bigger creditor, China, has a decreasing balance of trade surplus with which to buy our Treasuries, it is evident that interest rates can go up regardless of inflation, deflation or stagflation. Remember that the cost of housing increased while interest rates came down, something we should learn from, e.g., this is not your father's recession and that the World Economy has changed a lot about economic theory being turned upside down.

Pile on the international manufacturing of money and not having inflation would be remarkable. So don't take the short-term pump priming by governments as a long-term solution to deficit spending. In all probability, it may just be digging a bigger hole for future generations to dig out of.

Apr 12 02:22 PM

[Offline:]

IMHO, There will be parabolic inflation in near future as banks cannot sit ideal with papers...after a while, combined effect of monitory policy to combat sudden inflation (increase interest rates) and baby boomer's kicked in at 2011+ will create long term deflationary effects for at least 8-10 yrs..now with constant consumption by all these retirees(commodity etc.) + emerging mkts economical boom, there wont be enough workforce around to cover that tax gap and govt obligations. That will again jump start the inflation. I think after around 2020+ onwards.. everything will be back to normal with active workforce dominate retirees around 2040+ with another boom cycle. lets see how it goes..

Apr 12 11:46 PM

[Alan Young:]

You lost me in the second paragraph. If the yield was higher than expected, doesn't that mean that the demand was lower than expected?

Also, when Treasury bonds pay peanuts and all other assets are viewed as risky, TIPs are attractive just as a safe investment, even if inflation expectations are minimal. So this is a dubious indicator.

Instead, I'd look at the growth of money supply and velocity to measure inflation more reliably (although with shorter range capability).

Apr 13 01:52 AM

[Repsonsible...:]

Were did Your IRA and Retirement MONEY probably Go ? Right to Goldman Sac s via Goverment Bailout of $180 Billion bailout to AIG that money was transfered to GOLDMAN SACs to Pay off there worhtless CDS s So GoldMan didnt lose a Dime , course everybody else did Including YOU !! Dillan Radigan fromly of CNBC tried to Break the story two weeks ago he was FIRED the Next day ! There Should be a Federal Investgation Of Goldman but there wont be . Too Many powerful politcal players to stop it !

Apr 13 06:17 PM

[dcb:]

you can't make predictions about future inflation when traders control the markets and move it up and down at a whim

May 08 08:56 AM