Tuesday, October 11, 2011
This chart shows the entire history of the real yield on 10-yr TIPS. I've overlaid it with valuation parameters which make sense to me. TIPS are very different from ordinary bonds, since they trade based on real yields, not nominal yields. There is no limit to how high nominal yields can rise, especially if there's lots of inflation to contend with. But there is a practical limit to how high real yields that are guaranteed by the U.S. government can go. Ultimately, the real yield on TIPS is highly unlikely to ever exceed real growth expectations for the U.S. economy, otherwise TIPS would become an absolutely compelling alternative to just about any other asset class. For example, try to imagine how any asset class could beat a risk-free, U.S. government-guaranteed, real yield greater than 5% for 10 years? Can't be done. So as real yields approach or exceed 2.5-3%, then TIPS become very attractive since on a risk/reward basis they are highly competitive with just about any asset.
But while there is for all practical purposes a limit to how high TIPS yields can rise, there is no reason that they can't continue to fall, or become negative. In fact, as the chart above shows, real yields on TIPS maturing in less than 8 years already are in negative territory. Buy a 10-yr TIP today and over the next 10 years your total return will only be whatever the increase in the consumer price index proves to be. But anything less than an 8-yr TIP and you will receive less than the increase in consumer price inflation. A negative real yield simply means that the effective nominal yield on TIPS will be less than the future rate of inflation.
This next chart shows the nominal yield on 10-yr Treasuries, the real yield on 10-yr TIPS, and the difference between the two, which is the market's break-even, or expected annual inflation rate over the next 10 years. It's extremely important to note that the state of the Treasury market today is very different from what it was at the end of 2008, even though 10-yr Treasury yields are just as low now as they were then. At the end of 2008, 10-yr nominal yields briefly touched a low of 2%, but 10-yr TIPS yields were almost 2% as well, which meant that the market was expecting zero inflation for the next 10 years. Today, the difference between 10-yr nominal and real yields is 2%. That adds up to an expectation that consumer prices will rise by about 22% over the next 10 years.
In other words, the panic that struck at the end of 2008 was in part due to the market's belief that monetary policy was so tight as to preclude all thought of rising prices, as well as the widespread fear of a deep global recession or depression. It's dramatically different today, however, because the Fed and most other major central banks have made it clear that they will do whatever is necessary to avoid even the hint of deflation. Zero or negative inflation is not an option. Today's panic only extends to the outlook for growth. 10-yr TIPS are trading at a real yield of almost zero because the market fears that the outlook for economic growth is absolutely dismal. But buyers of TIPS and Treasuries today have almost no doubt that inflation will be about 2% per year for the foreseeable future. Put another way, if you worry about deflation, then you will shun TIPS and prefer Treasuries instead. (The same holds for inflation-adjusted bonds in the Eurozone, where break-even inflation expectations are also in the neighborhood of 2%.) A deflationary monetary error is not among the things that markets worry about today, and that, at least, is a source of some comfort. It's all about the outlook for Eurozone growth, it's not about central banks being too tight or too loose.
This analysis leads us to the following conclusions. If the economic outlook improves, then it is highly likely that both TIPS and Treasury yields would rise. 10-yr TIPS yields simply could not remain at zero if the market becomes more optimistic about the economy's ability to grow. If the economic outlook improves and inflation expectations rise, then Treasury yields would rise by more than TIPS yields. Put another way, if you expect the economy to have even the slightest chance of growing in the years to come, then you will find both TIPS and Treasuries to be very unattractive. If you expect the economy to eke out at least some degree of growth and if you expect inflation to rise, then you had better be prepared to see TIPS prices fall (since real yields would rise), even as rising inflation improved the effective nominal yield on TIPS.
Posted by Scott Grannis at 11:38 AM