Why You Should Worry About Negative Short TIPS Spreads

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From four years and shorter, the yields on TIPS reflect a belief that nominal inflation measured by the unadjusted CPI will exceed the yields on nominal treasury bonds. This should come as no surprise, except that it was so slow in coming. The CPI has been running at 3-4%+ annualized for some time now, and the sleepy TIPS market continues to estimate a 2-3% short-term CPI. That, in the face of a rising CPI. (Hey, a reason to buy TIPS! The actual inflation accretion is high than the implied accretion.)

Consider the following graphs:

Source: Federal Reserve, David Merkel

The first chart shows the TIPS-derived inflation breakevens taken from the smoothed series that the Federal Reserve puts out. It is interesting to note that the breakevens today are still below peak levels reached in 2005 and 2006.

The second chart takes the breakeven rates to maturity, and calculates the forward breakeven inflation relationships. In this case, the forward breakeven rates have been rising, particularly between five and ten year out, though they are still not at record levels.

The third chart looks at the forward inflation curves at five special points in time:

• 8/24/04 – Widest spread between expected five-year inflation, and ten-year inflation, ten years forward
• 9/9/05 – Largest inversion of the spread between expected five-year inflation, and ten-year inflation, ten years forward
• 6/29/06 – End of the tightening cycle, as I date it
• 8/10/07 – Beginning of the loosening cycle, as I date it
• The present

The present environment is unusual because of the relatively large difference between two-year inflation five years forward, and three-year inflation seven years forward. The logical play would be to go long seven-year TIPS, and short seven-year nominal Treasuries. As views on future inflation shift higher, the low implied rate of inflation in the seven-year part of the curve should adjust to the higher inflation forthcoming.

Now, why should the negative TIPS yields on the front end be a concern? Negative real yields, which are even more negative if trailing actual CPI figures are used, indicate even more inflation to come. Does this mean sell equities? No, but don’t hang out in long bonds. Keep your bonds short, and maybe buy some TIPS, say, 15 years out. Hedge by selling nominal Treasuries short, if you like. Negative real yields are a sign inflation is likely to accelerate, particularly when the Fed is showing no signs of raising rates, but has further decreases coming.

Comments

[EJW]

Yes on the bear-bull spread idea; see Hulbert in Barron's online week of 10 March.
EJW