Monday, August 10, 2009

TIPS update

One of the reasons advanced for the creation of TIPS in 1997 was that having inflation-linked bonds and nominal bonds issued by the U.S. government would reveal the market's inflation expectations in real time, and this in turn would provide valuable guidance to policymakers and to the market. By subtracting the real yield on TIPS from the nominal yield on Treasuries of similar maturity, you get the market's expectation for the average annual inflation rate over the life of the bonds. (It's also called the breakeven inflation rate, since if actual inflation proves to be identical to expected inflation, then the return on holding TIPS would be equal to the return on holding Treasuries of similar maturity.)

Of course, it's one thing to look at the breakeven spread on TIPS for guidance as to the market's inflation expectations, and it's quite another thing to believe that those expectations are likely to be proven right. One has to start out by assuming the TIPS market, as with any market, is better than any individual or collection of individuals when it comes to predicting the future. But markets can be and often are wrong.

The top chart here shows the breakeven inflation rate over the next 10 years, currently 1.96%. That's up sharply from the near-zero rate which prevailed at the end of last year, but it's a bit below the 2.04% average since TIPS were first issued in 1997, and it's well below the 2.5% rate which prevailed from 2004 through early last year. Not coincidentally, perhaps, the CPI has averaged about 2.5% over the past 10 years. From this perspective, it looks like inflation expectations are returning to "normal" but are still a bit on the low side.

The second chart shows the 5-year forward, 5-year expected rate of inflation (e.g., what the market expects the 5-year inflation rate to average, five years from now). This measure now stands at 2.5%, so we might say that from this perspective things are already back to "normal."

What's been driving inflation expectations higher? The easiest and simplest answer is that the economy has far exceeded expectations, and with a healthier economy, the market's fears of deflation have vanished. (I've discussed this at least several times in prior posts, most recently here.) But some portion of the rise in inflation expectations could be due to fears that the Fed's quantitative easing program will end up being inflationary. In any event, as the top chart shows, rising inflation expectations this year have been almost entirely the result of rising nominal yields, since real yields have been roughly unchanged. That's a clear sign that demand for TIPS has been relatively strong, and that would be consistent with rising inflation concerns. Still, breakeven spreads don't yet show any signs of rising to levels we haven't seen in the past, so it's tough to say on the basis of this evidence that the future has become problematic or that the Fed is likely to make a big inflationary mistake.

In my decades of experience, and after studying the history of countries that have experienced deflation, inflation, and hyperinflation, I have come to believe that bond markets are not always good or reliable predictors of inflation. The history of the U.S. is a case in point, since bond yields were chronically low relative to inflation in the 1970s, and chronically high relative to inflation from 1980 through the early 2000s. Plus, since its inception, the TIPS market has tended to underestimate actual inflation, as I noted in my last TIPS update.

The inflation expectations embedded in TIPS today are not unusually high, even though they have risen significantly year to date. But that doesn't rule out the possibility that inflation may end up being significantly higher in the future than it has been in the past decade. If the past is any guide, the TIPS market is likely underestimating future inflation. And if the Fed ends up succumbing to political pressures to ensure that the economy is growing, they may fail to unwind their liquidity injections in a timely fashion, thus providing the fuel for that higher inflation.

I don't want to downplay the threat of a Fed inflation mistake, especially given the sheer magnitude of the expansion of bank reserves and the fallibility of all mere mortals who are entrusted with great power. But I do want to note that while many are talking about the inflationary risk of current Fed policy, the TIPS market is so far displaying very little, if any, concern about this risk. Other markets, such as the gold market and the commodities market, do seem to be displaying a palpable degree of concern over rising inflation, since prices are relatively high and rising from an historical perspective. The gold market, for example, has been worrying about rising inflation ever since the Fed started easing policy in early 2001.

Given that the breakeven spreads on TIPS are still quite tame, and given that real yields on TIPS are not unusually low, I think TIPS are still the most affordable and least risky way to hedge against the risk of higher-than-expected inflation. And considering that they have no default risk and relatively low price volatility, TIPS can be superior to cash for many investors—particularly with cash yielding zero these days. Gold and commodities could rise significantly from here if the Fed really makes a hash out of things, but then again they could also drop significantly if big inflation turns out to be a no-show. Meanwhile, they pay no interest, whereas TIPS do.

Full disclosure: I am long TIP and various TIPS issues at the time of this writing.

No comments: