Monday, October 25, 2010
The real yield on 5-yr TIPS has been negative for more than a month now, marking a new milestone of sorts for the almost-14-year-old TIPS market. And as the top chart shows, the real yield on 10-yr TIPS is approaching zero, another new record low. What does this mean? In my view, the behavior of the TIPS market tells us that 1) the market has very low expectations for U.S. growth, and 2) the market's inflation expectations are rising, increasing the demand for TIPS.
One way to think of negative real yields on TIPS is like this: demand for TIPS today is strong enough that investors are willing to give up some portion of expected future inflation (equal to the amount by which real yields are negative) in order to gain the protection of TIPS. When real yields on TIPS are positive, investors can expect to receive the future rate of inflation plus a real yield "lagniappe." Those who purchase 5-yr TIPS today can expect to receive the future rate of inflation minus 55 bps per year. To be willing to give up some portion of future inflation is a sign of pretty strong demand for inflation protection, just as almost-zero real yields (and record-high prices) on 10-yr TIPS is a sign of very strong demand.
This next chart shows how real yields on TIPS have been depressed by declining yields on Treasuries. Inflation expectations (the difference between nominal and real yields) today are not too different from what they have been on average over the past decade, but nominal yields on Treasuries are at modern-day record lows. TIPS yields have to decline by at least as much as Treasury yields if inflation expectations are to remain constant. What we've seen since late 2008, on balance, is that TIPS yields have declined by more than Treasury yields as inflation expectations have risen. So a big reason for zero or negative real yields on TIPS is simply that Treasury yields are incredibly low.
Now, Treasury yields are incredibly low because the market believes that the Fed is not only going to engage in QE2, but that the Fed is also going to keep short-term interest rates close to zero for at least the next 12 months. Check the evidence: Fed funds futures contracts maturing in Feb. '12 are priced to the expectation that the funds rate will average 30 bps that month (note that it has averaged 20 bps for the past six months). In fact, since 2-yr Treasury yields are a mere 0.35%, this implies that the market expects the funds rate to average 35 bps over the next two years. In short, the market expects extremely low short-term rates for at least the next 2 years. This belief in low short-term rates for a long time automatically depresses yields on Treasury securities out to 10 years or so.
Admittedly, we are in uncharted waters here, with the prospect for another round of quantitative easing. But it's not unreasonable to say that expecting the Fed to keep rates close to zero for a very long time equates to a belief that the outlook for U.S. economy is nothing short of dismal. Imagine how yields would soar if the market (and/or the Fed) began entertaining the notion that the economy was starting to grow at a more health pace!
This next chart shows the recent, but strong correlation between the steepening of the long end of the Treasury yield curve and the market's 5-yr, 5-yr forward expected inflation rate. The former can be thought of as a measure of how much the Fed is artificially depressing 10-yr yields with QE2 and promises to keep the funds rate very low for a very long period. The latter is the Fed's preferred measure of the market's inflation expectations. By both counts, inflation expectations are rising, and rising in line with expectations that QE2 is essentially a done deal. The dollar has weakened and gold has strengthened as well (since the end of August when QE2 talk started getting serious), confirming that QE2 is likely to rekindle inflationary pressures.
As the next chart shows, there is a very strong and enduring correlation between the level of real yields on 5-yr TIPS and the market's expectations for future Fed policy (which I've proxied by comparing the 1-yr forward expectation for short-term interest rates to current levels of inflation). Real yields decline as the market expects the Fed to ease (with easing being defined as a reduction in the real short-term rate), and they rise as the market expects a future tightening. This makes sense if you realize that tighter monetary policy should reduce inflation fears, and that in turn should result in reduced demand for TIPS, which in turn means lower TIPS prices and therefore higher TIPS real yields.
Note that real yields today appear to have "overshot" expectations for future monetary ease. If I used a higher-than-current inflation rate, however, this overshoot would disappear since the 1-yr forward real LIBOR rate would become more negative. So this chart provides more evidence that the market is bracing itself for rising inflation.
From an investor's perspective, buying TIPS for inflation protection has become an expensive proposition. That's because the market is now embracing the idea that inflation is likely to rise (albeit not by very much), and the market demands that you "pay up" for protection. TIPS are also expensive because the Fed has pushed Treasury yields down to extremely low levels. Plus, both the Fed and the market have embraced the notion that the U.S. economy is going to be very weak (with a large "output gap") for a long time. If you expect to make money via rising TIPS prices, we're going to have to see the economy sinking into a double-dip recession, and/or the Fed surprising with a bigger-than-expected QE2 (since that would further depress Treasury yields). That's what it would take for TIPS yields to decline further (and TIPS prices to rise).
The real risk to TIPS today is not that inflation fails to rise, though that might depress their prices somewhat. The real risk is that the Fed fails to engage in QE2, or that the amount of QE2 disappoints the market's fairly aggressive assumptions. If the Fed disappoints and/or the economy improves, both real and nominal yields could rise significantly.
This is just one more way of saying that the extremely low level of Treasury yields is only tenable so long as the market and the Fed believe that the economy is in dismal shape. Investors have many trillions of dollars sitting in cash and in Treasuries because they have a deep and abiding fear of the future of the economy. Optimism is in very short supply these days, despite the the growing likelihood that next week's elections are going to mark a sea change for the better in the course of U.S. fiscal policy.
Posted by Scott Grannis at 11:57 AM