TIPS update

The big story in the bond market so far this year has been the gradual disappearance of deflation expectations. Nominal Treasury yields haven't changed much on balance (despite yesterday's huge decline), but real yields on TIPS have fallen significantly. The difference between the two yields represents the market's expectation of future inflation (aka the breakeven inflation rate). Over the next 10 years, the market expects the CPI to average about 1.3% a year; over the next 5 years about 0.7% per year. Over the next few years, though, the market still expects the level of the CPI to fall a bit. The market may be correct in its implicit view that Fed stimulus may take awhile to impact reported inflation. But sensitive indicators such as gold and the dollar are signaling that monetary policy is likely to push inflation higher, and it wouldn't surprise me if inflation went well above the 1.5-2% inflation that is expected five years from now (that's the measure the Fed likes to use: the five year inflation expectation, five years from now).

TIPS aren't nearly the screaming buy they were a few months ago (see my "TIPS are a steal" posts), because real yields have declined so much. But relative to Treasuries they still make sense. If you need something that is as safe as a U.S. government bond, TIPS are the best choice. It wouldn't take much of an increase in inflation expectations to make them pay off.

I would also note that the on-the-run 5- and 10-year issues are still much more highly valued than their nearby issues, because the market is willing to pay a higher price for new issues since they have more deflation protection built in. So if you are buying TIPS because you mainly want inflation protection, then steer clear of the OTRs. Better to buy seasoned issues, and if you're not an institutional investor, better to buy TIPS via a fund such as Vanguard's TIPS fund or Barclay's iShares TIPS fund; you'll get a better real yield and you'll save on transactions costs, because the TIPS market is still relatively illiquid, meaning bid/ask spreads are still relatively high.

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