TIPS update

One of the big stories this year—and one of the least reported—has been the disappearance of deflation risk. That is highlighted in the first chart here, in the area circled, which shows how the market's expectation of future inflation has risen. (Inflation expectations are calculated by subtracting the real yield on TIPS from the nominal yield on Treasuries of similar maturity.)

At the end of last year the bond market was expecting to see roughly five years of deflation, followed by 5 years of modest inflation, adding up to almost a zero net change in the price level over the subsequent 10 years. Just five months later, the bond market now expects inflation to average about 1.1% a year for the next 5 years, and 1.7% a year for the next 10 years. While this marks a pretty dramatic shift in expectations, the inflation discounted by bond prices today is still lower than it has been for the past 5 years, and lower than the inflation registered in any 10-year period since 1965.

Rising inflation expectations are also evident in the steepening of the yield curve. Despite the Fed's promise to buy up to $300 billion of Treasury bonds, T-bond yields have risen steadily this year even as short-term rates have hovered near zero. A rational investor would fully expect significant Fed purchases of T-bonds to result in higher bond yields, since those same purchases would increase the risk of higher inflation (i.e., debt monetization is a direct source of inflation). One of the Fed's own economists supports that view in a recent paper published by the St. Louis Fed. (It would appear that freedom of speech is still alive and well at the Fed, since the author of the paper directly questions Bernanke's belief that Fed bond purchases can lower bond yields.)

The second chart shows the level of real yields on TIPS, and suggests that at today's prices TIPS are fairly valued. I would not expect to see real yields decline much further, even if inflation expectations continued to rise, because I think that higher inflation expectations will be expressed primarily in rising nominal yields on Treasuries. If I'm correct, then the buyer of TIPS should not expect to see their price rise by very much, if at all; the benefits to owning TIPS will be realized primarily by a rising income stream if inflation proves to be higher than the market now expects.

I would be the first one to caution that rising inflation is not a good thing, but what we have seen so far this year—deflation expectations being replaced by modest inflation expectations—is a good thing I think. Reasonable men could argue about whether deflation is worse than inflation, but I think most would agree with me that it is better to have 1.7% inflation going forward than it is to have five years of deflation. That's particularly important these days, in view of the debt burdens that are weighing on so many people. Deflation compounds those burdens, since it makes acquiring the dollars to pay the debt harder, and it erodes the value of the assets and income streams that collateralize the debt.

Note that I'm not trying to argue that more inflation is going to result in more economic growth. Indeed, I think that the past decade of erratic monetary policy has contributed significantly to reduce the prospects for U.S. growth. A return to higher inflation means the return of speculation (of which there are already some hints in the commodities markets), and that runs contrary to the investment that is needed to produce lasting gains in productivity, which in turn is the only thing that can give us rising living standards. For now, it's best to focus on the positives that accompany vanishing deflation risk. Worrying about the consequences of rising inflation is a task for another day.

On that latter score, I would note the recent weakness in the dollar and the renewed upturn in gold prices, coupled with ongoing gains in commodity prices and a steeper yield curve. These are all portents of rising inflation pressures. Whether the Fed acts in a timely fashion to offset these pressures is going to be very important to how strong the recovery is going to be. If the Fed stays too easy for too long we will see a return of asset price bubbles and growth will be tepid. If the Fed tightens as necessary, confidence in the future will be strong and confidence in the dollar will contribute to a healthy investment climate, and that in turn will underwrite a bright future for the U.S. economy.

Bottom line: vanishing deflation risk brightens the outlook appreciably, but rising inflation risk means we shouldn't get overly excited just yet.

Full disclosure: I am long TIP and TIPS, and short T-bonds (via a long position in TBT), at the time of this writing.