Friday, June 5, 2009
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.
Posted by Scott Grannis at 12:07 PM