TIPS Yields Signal New Inflation Concern

 |  Includes: TBT, TIP, TLT
by: EconMatters

Source: U.S. Bureau of Labor Statistics

The spread between rates on 10-year notes and 10-year Treasury Inflation Protected Securities (TIPS), which reflects the outlook among traders for consumer prices, reached 2.13% last week, a 10-month high. This is the first time since the collapse of Lehman Brothers in September the spread surpassed 2%, implying an expected annualized inflation of 2+% over the next decade.

That marks a turnaround from the start of the year, when deflation was the main concern. Now, the massive amount of money being pumped into the system is sparking fears that the Federal Reserve will be unable to keep prices in check.

Inflation worries began to take hold in the past few weeks also pushing the treasury yield higher. Yield of 10-year notes hit 3.99% last week, 4 bps higher than before the auction, representing the biggest yield markup since May 2003, according to Morgan Stanley, and sharply higher than March’s 2.5%. The 30-year bonds also drew the highest yield in almost two years, at 4.81% from below 4.50% just a week before.

TIPS strength was also driven by the recent sell-off in nominal Treasuries as the deflation scenario fades, while budget deficits, protectionism and regulation inevitably will drive inflation higher. So far, Treasuries have tumbled 6.5% this year, the worst performance since Merrill Lynch & Co.budget deficit to $1.85 trillion while raising the risk of inflation. The U.S. may borrow $3.25 trillion in the fiscal year ending September 30, almost four times the $892 billion in 2008, according to Goldman Sachs.

Interest rates on business loans to mortgages tend to move in tandem with Treasury rates. There is growing concern about the trend’s potential impact on the wider borrowing costs crucial to a sustainable recovery. Meanwhile, the industrial production decreased 0.5% in April, and was 12.5% lower Y/Y. The capacity utilization rate fell to 69.1% in April, a new historical low since 1967. This unprecedented excess capacity could remain till 2015 before all the slack is used up, and that's if GDP grows 4.75% per year, based on Goldman Sachs estimate.

However, the economy is not likely to grow that fast because no significant investment will be needed for the next 2 or 3 years with so much excess capacity. The unemployment rate is heading over 10%, and maybe up to 12% next year. Even if job growth were to average 325,000 per month in coming years, it would still take 4 years to replace all the jobs lost in this recession. With so much excess labor capacity, wage growth will be weak for the next few years, which will make it harder for consumers to increase savings and spending.

The combination of higher debt, tighter credit, weaker business investment and consumer spending will make it difficult for a self sustaining recovery in the U.S. to develop in 2010. While it is likely that inflation could remain at low levels and stabilize in the next 2-3 years, it is at least as likely that it will overshoot old targets in the long run. A mixture of inflation, exchange rate depreciation and taxation are well documented responses by governments to high and rising public debts.

In order to gauge the overall inflation rate, it is important to look at the inflation rate of commodities, as commodities are directly tied to the effects of quantitative easing policies. Pricing change in commodities serves as a leading indicator to the overall inflation rate as commodities are inputs to all finished goods.

If we analyze the historical pattern of the U.S. Producer Price Index-All Commodities (Fig. 1) for the last decade,the average annual percentage change is approximately 4.3%. If history is any indication, the current expectation of an annualized 2% inflation rate for the next 10 years, given current quantitative easing policies, is grossly underestimated.

In this scenario, investors need to hold more overseas assets as returns on most domestic assets are likely to remain depressed. U.K. index-linked gilts, for example, could be a good place for a long position as the U.K. inflation rate is expected to reach 4.6% by the end of 2010, from 2.3% in April, providing higher return than TIPS, according to HSBC, Europe’s biggest bank. Investors also need to look for investment vehicles that can be highly adaptive to this new environment through alternative assets such as forestry with its protection against inflation and tax advantages to provide significant higher returns.

The stretch of 25 years, from 1982 until 2007, may be the best 25 years in U.S. economic history. But much of this prosperity was financed with debt. So, sometime in the last 25 years, we passed the point of no return. The coming new inflationary wave will likely transfer wealth from the consumers in the west to the producers in the east. The east will become increasingly attractive to free market capital as western countries become mired in the capital and wealth allocation dilemma.

Disclosure: No positions