TIPS Are the Proof of the Fed Distorting the Financial Markets

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 |  Includes: LTPZ, STPZ, TIP, WIP
by: Investment U

By Tony D’Altorio

Earlier, we took one look at QE2, the Federal Reserve’s proposed second round of quantitative easing. Now, let’s view it from another angle, as it looks like the Fed plans to enact this by purchasing as much as $1 trillion in assets. If so, that puts it – and the nation – into truly uncharted waters.

No one really knows what massive money printing will do over the longer term.

We do, however, know that the role of government in financial markets is growing. And as it does, so does the artificial pricing of securities.

Some claim that low Treasury yields showcase the U.S.’s status as a safe haven. But they ignore that the Fed and foreign central banks – which are just trying to keep their currencies from rising against the weakening dollar – are the key parties buying Treasuries right now.

Many nations even see QE2 as just the U.S.’s attempt to export its problems elsewhere.

Either way, the Federal Reserve has distorted the financial markets. Treasury Inflation Protected Securities, or TIPS, serve as proof of that.

Investors Love TIPS Promising Negative Yields

Investments that promise negative yields don’t sound very sexy. But scores of people “went negative” this week, snapping up $10 billion worth of 4.5 year Treasury Inflation Protected Securities.

With an astonishing negative 0.55% yield, buyers paid $1,055 for a $1,000 face value. (And no, we don’t think they were on drugs or booze while buying them.)

Pimco Portfolio Manager Tony Crescenzi described it this way:

The auction yield is striking, but it reflects a condition in the Treasury market that has been in place for months, chiefly that yields on shorter maturities have moved below the inflation rate. The auction put an exclamation point on the condition.

QE2 expectations have hit TIPS with both falling yields on standard cash Treasuries and fears of rising inflation. TIPS yields first went negative in August. Then September saw them sink lower on talk of the Fed concentrating its buying Treasury bonds with two to 10-year maturity.

But TIPS buyers still expect a positive return overall. They foresee inflation – thanks to programs like QE2 – over the life of the bond exceeding the negative yield.

They know that higher inflation can ravage regular bonds’ fixed rates.

TIPS, on the other hand, offer real yield and compensation for inflation based on changes in the government’s consumer price index. And this month, inflation expectations for the next five years hit a recent high of 1.75%… up from 1.13% in August.

That has fueled interest in TIPS, despite their negative real yields. The current, still low, inflation expectations make them look like bargains.

Used as a benchmark for TIPS, the inflation rate over the past six years averaged 2.5%. It hit a peak of 5.8% in July 2008 and bottomed in July 2009 at -2.8%.

If inflation rises, TIPS can help shield portfolios from higher consumer prices. Though that depends on whether the government’s consumer price index correctly gauges inflation levels or not.

How to Profitably “TIP” Your Portfolio

With all of this information, there are several ways to “TIP” your portfolio profitably. Purchasing TIPS directly from the U.S. government is one of them. Currently, there are 10 such auctions a year, but that should increase to 12 in 2011. For more information on that, just go to treasurydirect.gov.

Most brokerage firms also offer TIPS. So do certain ETFs, such as:

  • iShares Trust Barclays TIPS Bond Fund (NYSEARCA:TIP)
  • PIMCO 15+ Year US TIPS Index Fund (NYSEARCA:LTPZ)
  • PIMCO 1-5 Year US TIPS Index Fund (NYSEARCA:STPZ)

All three have a low expense ratio of only 0.20%.

Another ETF, SPDR DB International Government Inflation-Protected Bond ETF (NYSEARCA:WIP), offers global diversification. It invests in inflation-protected bonds of various maturities issued by Germany, France, Japan, Sweden, the UK and others.

Investing into a security with a negative yield may seem counter-intuitive at first. But the Fed’s QE2 may turn TIPS into a relatively safe port to ride out the oncoming storm.

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