Wednesday, November 4, 2009

TIPS get a whiff of inflation concerns





The TIPS market is finally beginning to understand that inflation is not going to be unusually low forever. As the first chart shows, the breakeven inflation rate on 10-year TIPS has risen to 2.1%, the highest level we have seen just before the Lehman collapse last year. (This same rate averaged about 2.5% during the 2004-2007 period.) As the second chart shows, the five-year, five-year forward breakeven rate (as calculated by Barclays) has risen to 2.6%, which is in fact a little higher than it was during the 2006-2007 period. Inflation expectations have been slowly working their way higher all year, and it shows up in the combination of declining real yields on TIPS, as demand for TIPS's inflation expectation increases, and rising nominal yields, as demand for unprotected bonds declines.

I've argued many times this past year that the bond market is not the best place to go looking for signs of inflation. That's because the bond market is heavily influenced by what the Fed says and does, and the Fed is not always right about the direction of inflation. Bonds (and the Fed) tend to be late to the inflation or deflation party, and that's one way that inflation or deflation feeds on itself.

So while the bond market's inflation expectations have increased substantially this year, it is not really sending any warning signals about inflation, but rather confirming what objective observers have known for some time: 1) deflation is a total no-show, and 2) inflation as we have known it for the past 10 years is still very much alive and well. Early this year the bond market was convinced that deflation was very likely for the next several years. Now, after watching oil prices almost double over the course of this year, gold prices rise from $875 to $1090/oz., and spot commodity prices rise by one third, the bond market has so far only concluded that it was mistaken about deflation. It has yet to figure out that higher inflation is the thing to worry about. That will be the next shoe to drop.

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

9 comments:

Bike said...

Scott - given your thinking concerning inflation - if an investor did NOT have any TIPS exposure (at this time) - would you advise taking a position in TIP/WIP/VIPSX/etc., now?

Thank you

CFP, EA said...

Bike,

Don't know Scott's feelings on buying TIPs at current prices. But for inflation protection, the first thing that I'd look at is your mortgage.

If you have decent-sized mortgage, refinance to take advantage of the low rates. That will protect a sizable part of your budget from inflation.

If your mortage is very low relative to your income (less of 1X your income), you might look into the refinancing where you pull some money out. A mortgage of 1.5 to 2 times income should be quite managable assuming that you don't have significant other bills such as alimony, parents dependent on you, etc. It'd be nice to get you mortgage above 50% of the value of the house, and preferably up to 80%. But, again, the size of the mortgage should be based on your income - and even then, only if you have very stable income.

Basically, you're leveraging up a real asset (your house), which should do well over the medium to long-term in an inflationary environment with a very cheap loan - ~3.5% after-tax. Then you take that money, invest it in a diversified portfolio - stocks (I prefer a globally diversified stock portfolio made up of index funds but that's an argument for another day), short-term bonds and/or TIPs. That portfolio should over the long-run (10+ years) do significantly better than 3.5% annually after tax.

TIPs may be a good investment, but when it comes to inflation, use the biggest, best assets suited to for the job: your house and mortgage.

Just an idea.

Scott Grannis said...

Bike: CFP makes some good points. Now is the time to be increasing your leverage generally (using fixed rate debt, not adjustable), rather than decreasing, and increasing your exposure to any tangible assets which have suffered sharp price declines (e.g., housing) rather than decreasing.

Leveraged exposure to real estate should be a good thing in a rising inflation environment, but it is nevertheless risky. TIPS are good if you are seeking safety; if you have money that you want to keep safe from the ravages of inflation. TIPS are an excellent alternative to holding cash. TIPS are much better than holding Treasuries.

Bike said...

CFP and Scott - thank you very much for your insights.

My situation w/regard to housing may be atypical. I rent ($520/month), do not own a house/real estate, do not want to buy/own where I am currently located, and know that in at most - 8 years, I will be moving at least half-way across the country (Illinois), if not all the way across to Washington State.

Hence, I have no mortgage, loans, etc.

I am (as I'm sure everyone is) looking for opportunities with a very good risk/reward - e.g., is now a point in time (given recent history - past 1 to 10 years) where TIPS look like they are undervalued, and if so - by how much?

Those (w/regards to TIPS) are two questions that I do not have answers to, and do not know how best to determine such.

Thank you again,
Bike

CFP, EA said...

Wow. Can't believe that I left out the most important part of that strategy. Always use a 30-year fixed mortgage. It's God's gift to the middle and uppper-middle class. Don't throw it away for an ARM.

The 30-fixed is almost - if not completely - nonexistent in the rest of the world where ARMs are the only loans available. And for good reason. Why would a bank want to lock in a rate over the 30 years. If rates go up, they're out of the luck. If rates go down, you refinance. It's a great deal.

CFP, EA said...

Scott,

Agreed that leveraged real estate can be risky. However, I think that risk is mitigated when you use your own house, where you expect to live for at least 7+ years. It's definitely a long-term strategy.

Scott Grannis said...

Bike: see my recent post for an answer to your question.

CFP: more good comments, thanks

Bike said...

Thank you very much.

Bike

Alexis said...

Great Information, and well worth reading.
Thanks!! I'll be back to see more.