Investors are betting that US inflation will start to rise as a result of sharply higher oil prices, evidence that the financial markets are pricing in a wider economic impact from the crisis in Libya.
Inflation expectations in the US have risen to their highest level since the summer of 2008, as the surge in crude boosts inflation-protected bonds.
The 10-year “break-even” inflation rate, as measured by comparing US Treasury yields with those of Treasury inflation-protected securities, or TIPS, touched a high of 2.51 per cent on Thursday, its highest level since July 2008. Inflation expectations for five years reached 2.26 per cent, the highest since the summer of 2008…...
(During) the deflation scare of last summer, when 10-year inflation expectations plumbed a low of 1.5 per cent,
- As I noted in my last article, the important data point to monitor with regard to TIPS is not the real yield on the TIPS alone but rather the break-even rate. Between August 30 of last year and March 4, the real yield on 10 year TIPS was basically unchanged. It went from .99% to 1%. But the conventional 10 year Treasury yield went from 2.50% to 3.49%. The break-even went up by a full 1% reflecting new market expectations. An observer looking only at real yields would have missed this sharp change in inflationary expectations.
- It would have been possible to lock in the old lower beak-even rate through a combination of purchasing TIP and purchasing DTYS the iPath U.S. Treasury 10-Year Bear ETN. The position in the TIP would have not changed much in price while the ETN value would have increased with the rise in 10 year yields.
- Focusing on the “low” real yield on the TIP would have been an incomplete analysis of the Treasury market. Looking at the low break-even rate vs. conventional Treasury bonds would have led to the conclusion that given the choice the conventional Treasury with a nominal yield of 2.50% was a far inferior investment to the TIP with a .99% real yield.
- Looking at total return since the low period for the break-even rate (and for nominal Treasury bonds) the TIPS were far superior.
The volatility of those same instruments is seen below. As expected, the longer the maturity of the TIP ETF the greater the volatility. Also notable is that the TIPS had less volatility than conventional bonds.
Volatility (standard deviation):
Disclosure: My clients have positions in TIP, and STPZ