Friday, June 5, 2009

TIPS update (2)

Last November I said that TIPS were so attractive it was hard to believe, because the market was pricing them to the expectation that we would see at least 5 years of deflation, whereas I thought the Fed's aggressive quantitative easing program would eliminate the deflation threat and likely give us much higher than expected inflation. Things are working out pretty much as I expected. TIPS real yields have declined as demand for inflation protection has risen, while nominal yields on Treasuries have jumped. The difference between the two is the market's expected, or breakeven inflation rate.

10-year inflation expectations have jumped by 2 percentage points since the end of last year, but they are just getting back to where they were before this whole housing debacle got started. I think there is plenty of room for inflation expectations to continue to rise. Every day that the Fed delays in taking back the $1 trillion it has pumped into the system means inflation pressures are increasing. Commodity prices are up across the board. Gold is threatening to break $1000. The yield curve is historically steep. All of these are fundamental signs that monetary policy is inflationary.

Unless the Fed takes drastic action to shrink its balance sheet soon, I expect we'll continue to see nominal yields rise while real yields stay relatively stable. TIPS don't have a lot of upside price potential, and they shouldn't be at risk of a significant price decline unless and until the Fed decides to get tight. But their yield will increase as reported inflation increases. As such, TIPS are an excellent safe haven for money that needs to be sheltered from risk over the next year or so.

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


lb100 said...

I appreciate your view that the transactions costs of owning individual TIPS can be prohibitive, but I'm curious about your thoughts on the interest rate risks carried by TIP and VIPSX. I know that the pricing of TIPS funds is very complicated, but from my distant and not very informed vantage point, it has appeared to me over the past year that VIPSX responses to interest rate changes are comparable to its inflation expectation responses, at least those indicated by breakeven rates. Nominal interest rates should rise with greater inflation (Fisher), so could the price of TIP and VIPSX, and other funds subject to interest rate risk actually decline with increasing price levels (as VIPSX seems to be doing right now)?

And what about the vintage factor? VIPSX is an intermediate fund (4.2 years), while TIP is relatively long term (7 years). If interest rate risk is a significant problem for VIPSX, it may be huge for TIP.

Scott Grannis said...

TIPS have two prices: the one that changes as real yields change (the market price), and the one that is adjusted daily by the CPI. The market price is indeed subject to the risk that real yields rise. Typically, real yields rise as the expectation of future Fed tightening rises. I've done a lot of research which shows that the real yield on TIPS is heavily influenced by the market's expectation of the real fed funds rate.

So when the Fed really gets serious about tightening, real yields will probably rise. That makes a lot of sense in any event, since a tight Fed will reduce inflation risk and that in turn will reduce demand for TIPS.

If you are worried about Fed tightening, then you would be better off buying the shorter duration TIPS fund. You give up some real yield, however.

Another interesting thing about TIPS is that real yields, unlike nominal yields, can't rise forever. I think the uppper limit on real yields is somewhere in the 3-4% neighborhood. So all TIPS most likely have a price floor, unlike TReasury bonds whose price can fall and fall and fall.

bitbucket255 said...

I'm trying to get a handle on what the Fed and the bond market will be doing in response to the impending deficit problem. I.e., the federal government has to sell a lot more debt instruments over the next 5+ years to cover growing deficits. Supply & demand seems to indicate that selling more notes means the rates must be sweetened.

If the Fed Funds Rate is increased, and Treasury rates follow, will the higher nominal yields bring more buyers to the Treasury auctions?

And will intermediate and long term rates lead or lag the inflation rate?

Scott Grannis said...

I think there are two major forces that will impact the bond market: 1) the strength or weakness of the economy and 2) the size of the federal deficit.

As long as the market sees the economy as weak or very weak, the government can probably sell a whole lot of bonds without causing interest rates to rise very much.

But as soon as the market senses that the economy is not weak and may even be growing (as I think is the case today), then the prospect of massive Treasury auctions for as far as the eye can see become very problematic.

If the economy continues to improve, and Obama and the Dems don't scale back their spending ambitions, then I don't see why interest rates on Treasuries can't go a whole lot higher. It's only a matter of how high. We'll just have to wait and see. Higher rates will attract the necessary buyers--we just don't know what will be the rate that clears the market.

If the Fed is slow to react, then all rates will lag the inflation rate. That's how inflation happens.