Thursday, March 15, 2012

TIPS update--not very attractive



The top 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 expected average annual inflation rate over the next 10 years. The bottom chart focuses on the real yield on 10-yr TIPS, and overlays my estimate of how intrinsically valuable TIPS happen to be at different levels of real yields. The lower the real yield, the less intrinsically valuable TIPS are, because TIPS are a unique asset since they pay a government-guaranteed real yield—nothing else can make that claim. (TIPS are Treasury bonds whose principal is adjusted by the CPI, and whose coupon is therefore a real yield.) TIPS are very expensive today because they actually have a negative real yield. TIPS would be attractive relative to Treasuries if inflation proves to be higher than expected, but with a guaranteed real yield that is negative, TIPS are not necessarily attractive at all in an absolute sense.

The long-term story told in the top chart is that ever since TIPS were first issued in 1997, nominal and real yields have been in decline, but the difference between the two hasn't changed much on balance. Inflation expectations have moved up and down, but current inflation expectations are not greatly different from the inflation we've actually experienced over the past decade: current inflation expectations are 2.38% for the next 10 years, while the CPI has averaged 2.48% over the past 10 years.

So the only thing that has really changed is real yields, which have declined from 3% to zero. The decline in real yields has brought with it a decline in nominal yields, since inflation expectations haven't changed much. I think real yields have declined mainly because the economy has run out of gas, and that has depressed the market's expectations for real returns across a variety of assets. Think of TIPS as defining the zero-risk real rate of return for various maturities of assets in real, inflation-adjusted space. 10-yr TIPS today are saying that if you want to lock up your money for 10 years with no possibility of default, then you must accept a slightly negative real rate of return. All other long-term assets offer a higher expected real return, along with the risk of principal loss. Put another way, 10-yr TIPS are telling us that the market believes that other, risky assets on balance don't have the potential to deliver much more than, say, a 1% real rate of return or slightly better. The expected real return of all assets has declined along with the decline in TIPS real yields, and that can only mean that the market does not expect much real growth from the U.S. economy. In short, the real yield on TIPS is inextricably linked to the market's expectations for economic growth.


The economy's poor performance in recent years is directly reflected in the growing gap between real GDP growth and its 3% long-term growth trend, which has widened since 2006, when real yields were about 2.5%. The Fed, via its quantitative easing policies and its "operation twist," has encouraged nominal yields to fall, in the hopes that lower long-term yields would help spark stronger growth. But since monetary policy cannot create growth out of thin air, the Fed's efforts cannot raise growth expectations, and they cannot—by extension—push real yields higher. If anything, aggressive monetary ease likely reduces growth expectations, since easy money increases the incentives to speculative (i.e., non-productive) activities.

If the economy starts to pick up—exceeding the current dismal expectations of market participants—and the GDP gap starts to narrow, then we should see higher nominal yields, because the market will begin (as it has in recent days) to ratchet higher its expectations for Fed tightening. Real yields are likely to rise as well as economic growth expectations improve. If inflation expectations increase alongside a pickup in growth expectations, then the rise in nominal yields should exceed the rise in real yields.

The price of TIPS is thus quite vulnerable to any unexpected strengthening of the U.S. economy, regardless of whether inflation proves higher than expected or not. A TIPS investor would benefit directly from higher inflation, but at the same time suffer a decline in the value of TIPS. So TIPS are not a very "clean" or cheap inflation hedge, since the gains from higher inflation would likely be eroded by the loss from higher real yields.

To sum up: TIPS are only attractive to an investor who believes 1) that inflation will prove to be higher than expected, and 2) that economic growth will continue to be disappointing.

10 comments:

Squire said...

I have read a hundred times that when bonds and stocks diverge, the bond market is always correct. This time I think not and bond yields are going to converge on the stock market. If not, those economists calling for a contraction later this year will be heroes. But how bad will a contraction be? One thing is that it would ensure Obama’s loss in November. This would be good for the economy. If the polls show an easy win for Romney or Obama, such will be priced into the markets. Try playing that!!!

My counteractant indicator for stocks is way overbought on an up market today so if it holds true, there will be a nice buying period coming up. If not true, I might have to go back to fundamental analysis. Hah! I will shoot myself first.

DownSouth said...

Scott,

Thanks for your in-depth commentary. It is much appreciated.

Buddy R Pacifico said...

It looks like TIPs are attractive during a period of stagfaltion. If the next five to ten years are slow growth and inflation >3.5% then TIPs might be will be attractive.

Smruti said...

Thanks for this post. I have been trying to wrap my head around TIPS valuation for a while now. Almost had a epiphany after reading this!

Buddy - I agree, a not too high inflation stagflation scenario probably is the best one for TIPS. But the nominal yields are going to move based on rate hike expectations. So a more hawkish Fed (obviously not Bernanke) will be bad for TIPS regardless of the level of inflation.

Rob said...

Dear Scott,

I have been running a small position on TBT, ie betting that US government bonds will get cheaper ... it didn't seem to be doing anything, staying range-bound, but then two days ago it jumped 100 points in a day, having run up the day before. This one-day move was bigger than anything seen (upwards) for many months. My question is: what the heck caused that sudden move ? I couldn't see any headlines to account for it on that particular day !

Many thanks.

Dr William J McKibbin said...

In the event of any inflation in the future, bondholders stand to be wiped out -- as inflation (and rates) go up, existing bond yields collapse...

Richard Warr said...

Is it correct to say that the early period of "extreme cheapness" was really due to TIPS being new and most institutional investors weren't buying them. Only as the institutions started getting on board did the real rate start to fall?

Great post and blog BTW.

Scott Grannis said...

Robert: re why TIPS were so cheap in the early years. I think there are two reasons: 1) as you say, not many people were focused on TIPS at the beginning, so the market didn't really appreciate how cheap they were, and 2) real yields on all Treasuries were very high because monetary policy was very tight. The economy tolerated high real yields for several years because growth was very strong (strong growth should go hand in hand with high real yields). The second explanation is the more robust one.

Ken Faulkenberry, ArborInvestmentPlanner.com said...

Investors learned that TIPS could protect them from inflation and have bid up the price. Currently, with no real yield, it only leaves real estate and equity assets for inflation protection. Isn't that what the Federal Reserve wanted us to do? (No good options!)

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