TIPS Are No Longer a Steal

With gold making new all-time highs ($1042/oz. as I'm writing) and the dollar on the verge of a new low for the year, it's once again time to revisit TIPS. Gold is sending a powerful inflationary signal, yet TIPS continue to be priced for a benign inflation outlook. What gives? I've commented on the issue of bond market complacency before, and this posts revisits the subject from a slightly different perspective.

I was a big fan of TIPS late last year, when expectations of a deep deflation caused their price to collapse and real yields to surge; I thought that the market then was way-overestimating the risk of deflation, and TIPS were therefore very cheap. Since then, real yields have declined and TIPS prices have risen, while deflation risk has almost disappeared. Yet the TIPS market is not even close to getting the inflation jitters. As the first chart shows, the inflation expectations built into 10-year TIPS call for the CPI to average less than 2% a year. That's rather astounding, considering that the CPI has averaged 2.6% for the past 10 years, and monetary policy is currently extraordinarily accommodative. Breakeven inflation expectations for the next 5 years are only about 1.4% per year!

The best explanation I can come up with for why the bond market is so complacent about inflation risk is that the market is assuming that the outlook for U.S. economic growth is abysmal. That adjective might be a bit of an exaggeration, but when 10-year Treasury yields are only 3.25% my first thought is that the market doesn't think nominal GDP growth is likely to exceed 3% for the foreseeable future. (Nominal GDP has averaged 5.1% over the past 20 years, and the 10-year Treasury yield has averaged 5.5%.) By inference, since the Fed has basically sworn to give us positive inflation, that means real growth of 2% or less. And that, in turn, would not be enough to bring unemployment down for a very long time. A few years of 2% growth would leave the country and the electorate extremely frustrated, to put it mildly. It is also the case that the market firmly believes in the Phillips Curve theory of inflation, which holds that a prolonged period of subpar growth would translate into extremely low inflation, no matter how aggressive the Fed tries to be.

So Treasury yields, both real and nominal, are very low because economic growth and inflation expectations are very low. There's simply no other logical explanation in my book.

As the next chart shows, real yields on 10-year TIPS are now trading at the low end of their "fair value" range (as determined by me). This reinforces the argument I've made in recent months that TIPS are no longer a steal. They are however an excellent alternative to holding cash, since cash yields are almost zero, and TIPS are a great vehicle for money that one wants to keep safe from the ravages of inflation. They are also likely to do much better than Treasuries of comparable maturity if and when inflation picks up.

It wouldn't take much of a pickup in inflation for TIPS to pay off handsomely, at least relative to cash or relative to holding regular Treasuries. If inflation picks up up to, say, 4-5% or more, then I would fully expect the demand for TIPS to be quite strong, and that would likely keep real yields on TIPS at least steady, if not push them lower. Meanwhile, stronger-than-expected inflation would undermine the Treasury market, with the result that nominal bond yields could rise significantly from current levels.

A word about risk is probably in order. The main risk to owning TIPS right now is that the Fed might begin to tighten policy sooner than the market expects. The blue line in the next chart is essentially the market's current expectation for what the real Fed funds rate will be one year from now: about 0%. The market sees very little chance for any meaningful tightening of monetary policy for at least another year or so. The expectation of very low real short-term rates keeps real yields on TIPS very low, just as the expectation of a very low funds rate keeps yields on Treasuries very low. (That's why the red and blue lines track so well.)

So if the Fed tightens policy even just a little bit (by raising the funds rate above the level of inflation), that will put upward pressure on TIPS yields and downward pressure on TIPS prices. In short, a tighter-than-expected Fed would means less inflation risk, and that in turn would mean less demand for TIPS and higher TIPS real yields.

If you're looking for more info on TIPS, I've written numerous posts over the past year.

Full disclosure: I am long TIPS and TIP at the time of this writing.

Comments

[notsosmart:]

cant have inflation with so many unemployed. some will never work again.lets see how many retailers will close after this holiday season.most consumers have more than enough chinese junk.in cold climate states the budget will be strained by heat energy costs.if you dont go to work you need a lot less of clothing,gasoline & auto service,food costs,dry cleaning etc.the spiral is going the wrong way.

Oct 07 05:12 PM

[Thomas J. G...:]

I have another explanation for why the 10 yr is low 3's and the 30 yr is at 4. u.s. banks gave up trying to figure out which resturaunt in town was going to be successful and pay back their business loan and started borrowing at fed funds at close to 0 and buying treasuries yielding 3 and 4%. I think the author is very economically literate but I no longer look at treasury pricing as inflation plus some real return. The fed wanted low rates and figured out a way to get them by manipulating the market. Maybe domestically with u.s. banks and also giving some foriegn buyers incentives to buy treasuries. This drove the yield on treasuries down even though the safe haven appeal of treasuries is waning.

Oct 07 05:52 PM

[Gardener:]

I don't think that the gold price is reflecting inflation expectations but more likely a currency crisis.

Oct 07 05:53 PM

[Joe Duggins:]

One steady bit of good economic news: Inflation remains near zero. So who would want to pay extra these days to add a dose of inflation protection to their portfolio?

Plenty of people, as it turns out. Sales are hot for Treasury Inflation-Protected Securities, a common hedge against rising prices best known by their acronym TIPS.

New money from investors and market gains have boosted total assets in mutual funds investing in TIPS nearly 36 percent this year, to $57 billion at the end of August, according to Morningstar Inc.

It's part of a broader shift by many investors who have been scared away by stocks, despite the market's sizable rebound from its March lows. They've been piling into the greater safety of bonds, and TIPS — though not without risk — are about as safe as investing gets.

The value of the underlying investment in TIPS rises with inflation, providing an additional layer of protection beyond what Treasury bonds offer.

Inflation isn't widely expected to re-emerge as a substantial threat in the near future, so TIPS aren't necessarily the best short-term investment. But historically low interest rates and the federal government's growing deficit are expected to drive prices higher, especially once the economy truly gets back on its feet and spending rebounds.
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Oct 07 07:38 PM

[fwi:]

The bond market can no longer act as inflation vigilantes because the government has muscled out the natural market forces. It is on both sides of all the action, and is confusing the signals. This is very dangerous, as the bond market signaled the financial meltdown last year while the equity market was flying high. All we are getting now is Treasury and Fed spin. This will not end well.

Oct 07 09:28 PM

[tripleblack:]

I was thinking the same thing earlier today. I was wondering when the first fight between Geithner and Bernanke over the need to raise rates would occur...

If these two go seperate ways, it will get wierd.


On Oct 07 09:28 PM fwi wrote:

> The bond market can no longer act as inflation vigilantes because
> the government has muscled out the natural market forces. It is on
> both sides of all the action, and is confusing the signals. This
> is very dangerous, as the bond market signaled the financial meltdown
> last year while the equity market was flying high. All we are getting
> now is Treasury and Fed spin. This will not end well.

Oct 07 09:49 PM

[The Geoffster:]

Correcto. The dollar is just paper and gold is, well, gold.


On Oct 07 05:53 PM Gardener wrote:

> I don't think that the gold price is reflecting inflation expectations
> but more likely a currency crisis.

Oct 07 10:05 PM

[JAMES CARLINI:]

I think the first commenter notsosmart has a good observation - <you can't have inflation with so many unemployed>

I would take his comment a little further and say that there are many people underemployed. You can't spend at the rate when you were making $80K-$120K if now you have a job paying $35K-$45K.

Somehow those that are underemployed are not getting picked up on the radar of those who comment on the effects of the 10% or so unemployment. If we could track underemployment, it is at a much higher percentage and the impact on spending is even greater because these people spent money (they were at a much higher salary). Now, they are not spending anything.

Oct 08 01:20 AM

[nobby73:]

You can have price inflation with high unemployment, as any country that has experienced a currency crisis can attest. The inflationary effect of rising input prices destroys profit margins and puts many workers, out of work. Sure, you do not have monetary inflation (as in velocity of money), so this may be more correctly called stagflation, but simply put, it costs more money for the same standard of living.

It may initially appear that things are getting cheaper, as there are more distressed sellers, but businesses need to make a profit to survive in the longer term.

Too many people seem to thing that the US is an economically independent entity but the country has had a hugely negative balance of trade for as long as I can remember.

Clearly, the biggest factor is the cost of oil.


On Oct 08 01:20 AM JAMES CARLINI wrote:

> I think the first commenter notsosmart has a good observation -
> <you can't have inflation with so many unemployed>
>
> I would take his comment a little further and say that there are
> many people underemployed. You can't spend at the rate when you
> were making $80K-$120K if now you have a job paying $35K-$45K.<br/>
>
> Somehow those that are underemployed are not getting picked up on
> the radar of those who comment on the effects of the 10% or so unemployment.
> If we could track underemployment, it is at a much higher percentage
> and the impact on spending is even greater because these people spent
> money (they were at a much higher salary). Now, they are not spending
> anything.

Oct 08 05:43 AM

[chap08:]

You certainly CAN have inflation with so many unemployed. Look at it a couple of ways:

1. MV = PQ. It doesn't say anything about unemployment in there. Take the economy as it is and double M. What happens? Anyone remember the 70s? With expansionary policies in place, they even managed to get positive CPI for the years 1934 to 37.
2. CPI inflation has not been determined by domestic factors for many years. It is determined by imported inflation. The dollar has fallen recently and oil has stayed strong. That signals higher imported inflation and so higher CPI.


On Oct 08 01:20 AM JAMES CARLINI wrote:

> I think the first commenter notsosmart has a good observation -
> <you can't have inflation with so many unemployed>
>
> I would take his comment a little further and say that there are
> many people underemployed. You can't spend at the rate when you
> were making $80K-$120K if now you have a job paying $35K-$45K.<br/>
>
> Somehow those that are underemployed are not getting picked up on
> the radar of those who comment on the effects of the 10% or so unemployment.
> If we could track underemployment, it is at a much higher percentage
> and the impact on spending is even greater because these people spent
> money (they were at a much higher salary). Now, they are not spending
> anything.

Oct 08 06:12 AM

[JAMES CARLINI:]

chap08 -

You show some formulas that have given results based on "input".

What I was trying to say is that if you DON'T put in ALL the variables into an assessment and then run the formulas you trust, the results are going to be inaccurate.

Underemployment is not being assessed or added to the analysis. By that omission alone, I do not buy off on the assessments being given as fact and "fitting the formula".

As to your assessment that Oil stayed strong. I don't follow that.

It was $140 a barrel with experts claiming it would go to $200 - $300 a barrel, if not more. NEVER happened.

WHY? The consumer started cutting back. It dropped.

Where are all the experts and their formulas that predicted that eventuality??

Not everything fits into a formula AND variables you do not or cannot measure do effect the outcome.

Oct 08 09:06 AM

[Thomas J. G...:]

Joe, You make a good point about inflation. People put Bernanke and Greenspand down, but imho we haven't had any inflation for over 20 years and that's good. I guess M1 has soared, I guess we are really in for it, but until I see bacon and gas double in price I'm not going to say that Bernanke and Greenspan blew it on the inflation front. And they did this with the federal gov't running large deficits, so more power to them.

Oct 08 12:08 PM

[Viewpoints ...:]

It is tough to make predictions, especially about the future. - YOGI BERRA

I keep CNBC on all day while I work. Perhaps I think I will miss something, or maybe it’s the background noise that’s appealing. In any event, what I always find amazing is the parade of experts making one prediction after another. I think I would fall out of my chair if I heard one of them say “Well, to tell you the truth Mark, I have no idea”.

What’s most surprising is the arrogance in which these forecasts are made. The forecaster always seems convinced he is right. I think the world is far more complicated than we think, yet we always seem to place way more value in what we know over what we don’t know. If you are an auto mechanic, you most likely know more about fixing cars than you don’t know about fixing cars. Also, errors are easily rectified. In this light, a good mechanic is an expert.

If you are a psychologist or an economist, I don’t think so. In fact, it’s practically impossible that your knowledge of the human condition would exceed your lack of knowledge of the human condition. Not to mention that mistakes can be catastrophic in these “big system” type professions. Plumbers don’t kill people but doctors do. Mistakes when predicting the weather, the economy, or the financial markets can and do ruin our lives. Nothing is as potentially dangerous as a rational prediction in an irrational world. So, are there really experts in these professions or are they just the one-eyed men in the land of the blind? I Guess Yogi Berra, the great baseball player/coach had it nailed when he said “It is tough to make predictions, especially about the future.”

I think we love predictions because if we make predictions, and/or concoct explanations for those events we predicted wrong, then we won’t feel like victims of randomness. We feel more in control. But are we more in control or just intoxicated by some illusion of control?

In his book “The Black Swan” Nassim Taleb says, “We have seen how good we are at narrating backwards, at inventing stories that convince us we understand the past. In spite of the empirical record we continue to project into the future as if we were good at it, using tools and methods that exclude the rare events.” Funny isn’t it, since the big, rare, unpredictable events are precisely what shape the world. Events like the automobile and the World Wars, the internet and the Beatles.

I think it’s ironic that by accepting we have little control over most things, actually gives us greater control over what might happen. By realizing our lack of control we may be able to minimize the more negative events. If we realize anything can happen when trading commodities, then we are more likely to actively manage our exposures to big loss and potential ruin.

Oct 08 12:17 PM

[Marcio:]

The economic stimuli are not as inflationary as it looks at first glance: if, on one hand you've increased the money suply, on the other the credit crundh greatly reduced money's velocity, so M4 is not growing at the same pace as M1.

Oct 08 12:42 PM

[oldman:]

Thanks for the commentary. Good stuff. Would also like to have some education on the information and how to use data that is sent monthly by treasury on the index + CPI.

Oct 08 02:34 PM

[andruomail:]

If you're a bank and take out a fed funds loan from the Fed, that's not a long-term loan, correct? wouldn't it be suicidal for them to buy long-dated Treasuries in this way if interest rates ever rise? I do read this theory a lot though.

> I have another explanation for why the 10 yr is low 3's and the 30 yr is at 4. u.s. banks gave up trying to figure out which resturaunt in town was going to be successful and pay back their business loan and started borrowing at fed funds at close to 0 and buying treasuries yielding 3 and 4%. I think the author is very economically literate but I no longer look at treasury pricing as inflation plus some real return. The fed wanted low rates and figured out a way to get them by manipulating the market. Maybe domestically with u.s. banks and also giving some foriegn buyers incentives to buy treasuries. This drove the yield on treasuries down even though the safe haven appeal of treasuries is waning.

Oct 08 05:31 PM

[realold:]

You can have inflation when the value of the dollar declines and other nations are doing well - they bid up the price of all comodities - you are stuck with worth less dollars - you have inflation and no one is employed.
Not saying it will happen, but inflation here is not dependent on jobs here.

On Oct 07 05:12 PM notsosmart wrote:

> cant have inflation with so many unemployed. some will never work
> again.lets see how many retailers will close after this holiday season.most
> consumers have more than enough chinese junk.in cold climate states
> the budget will be strained by heat energy costs.if you dont go to
> work you need a lot less of clothing,gasoline &amp; auto service,food
> costs,dry cleaning etc.the spiral is going the wrong way.

Oct 08 09:22 PM

[Delojozafado:]

A lot of arguments here as to whether the inflation or deflation or the price of gold etc. So what! I have investments with good gains in both WIA and TIP. So do I sell ? I think I will hold for the really great distributions as against my cost basis and their being by nature some kind of bunker. Since the melt down I have moved from 65% bonds to 50% bonds and continuing to reduce. Last week I got another tender offer filled on $10K for $10.5K on some '11s. Now I figured with the interest I can earn going forward and the $500 premium to par then I am going to be ahead by 4/11 when the bonds would have been redeemed at par.

I had already figured out a month ago what the author is pointing out. So then what do we do? I started buying GYB the Goldman Sacks floating rate derivative at 5.8%. I guess that was a good idea then!, so now it is 5.25% and I am not so enamored of it. So this past couple weeks I added some GGC with all it's complexities with premium/discount/ROC the whole mess and yet as long as these gold and Nat resources continue higher then the 10% yield will hold up? Probably not but then even with a correction down near $900 on gold the TOTAL return should work as well as the TIP and WIA, especially if they do get legs again. Friday I added a 100 of VZ as an initial position for the 6.4%.

I would appreciate some posters posting some alternative same concept ideas to TIP instead of debating the finer points of what may happen or maybe is happening in the inflation debate. Google "Mark Hulpert/ Bonds and gold"... for a very well thought out piece on that debate.

While I was nearly 4% exposed to precious metals I recently have been trying to get that increased to 6.5% by buying HL-PC (Suspended but) cumulative and some GGC. I have also in the last two weeks added 5 Canadian Platinum Maples to my bullion position.

With so many bonds either medium term funds like LQD, CIU,MIN & DUC, or short term individual Corporates I have been taking out some insurance on a dollar cost averaging basis in PST,TBT and more recently adding some TMV as well. While I am down +3K in that combined position most of my preferred stuff with long term exposure is up +30%. REP-PA, ADM-PA, HCN-PG, JPM-W, OHI_PD,AES-PC , GFW,GFZ, DKT. I am trading in lower yielding bonds for high yielding long maturitiy Preferreds and stocks like BRPFF,ATPWF,NFYIF,ATBUF, OTT ,BLIAF, any thing that is better than a 6.5% yielder with growth and of megatrend capacity.

Every time I discover another gem like GYB,GFW and GFZ "they" swoop down and drive the price higher before I get a chance to add to the position at any kind of decent valuation.

Those are some IDEAs I am getting itchy on in waiting for this next sell off like we last saw in July. It is sure to come and I want to be ready to nail down some good stuff cheap. IAF is looking good to me now but too richly valued. I keep waiting for BLIAF to knock off 50 cents some morning so I can add. All this stuff keeps going higher . Tips are not the only thing getting way over valued!

WE saw the ten year note hit 3.14% on Thursday 10/8 mid-morning.
On Friday we saw it sell off sharply making a 3.4% mark intra-day finishing at 3.384. That is a fairly large 2 day swing. So maybe the next move in the Ten year back to the 4% level we saw in the spring may have already started and income investors that stayed patient hoarded cash ansd hedged longer term maturities will finally have a chance to buy into the Medium term market again for good solid yields.

Oct 10 11:46 AM

[a fat panda:]

"cant have inflation with so many unemployed."

Look at Zimbabwe. You can.

Inflation is a very destructive force because it embeds risk in every transaction in the system. Look at auto insurance for example, when the insurer prices his product. First it factors in the likelihood and costs of the auto wreck. Then it factors in the likelihood of the currency wreck. Inflation makes any future transaction more difficult to price.

In periods of high inflation, future pricing is almost like trading in a foreign currency. The further out you go the more hedge you have to embed in your price. If that doesn't sound like something that would create unemployment I don't know what does.


On Oct 07 05:12 PM notsosmart wrote:

> cant have inflation with so many unemployed. some will never work
> again.lets see how many retailers will close after this holiday season.most
> consumers have more than enough chinese junk.in cold climate states
> the budget will be strained by heat energy costs.if you dont go to
> work you need a lot less of clothing,gasoline &amp; auto service,food
> costs,dry cleaning etc.the spiral is going the wrong way.

Nov 07 08:15 AM