Thursday, May 17, 2012
As the world agonizes over a Greek default/banking implosion spreading to the rest of the Eurozone, I thought it would be good to revisit what is going on in the TIPS market. The first chart above compares 10-yr TIPS to 10-yr Treasuries, while the second looks at the 5-yr version of each. Nominal and real yields are on the top of each chart, and the bottom line is the difference between the two, which is the market's expectation for annual inflation over the life of the bonds.
Not surprisingly, both charts show the same patterns. The dominant pattern is that real and nominal yields are moving down at pretty much the same pace, with the result that inflation expectations are not much different today than they have been on average over the past 15 years. The important trend here, then, is the decline in real yields, which is being tracked by the decline in nominal yields; since inflation expectations haven't changed, nominal yields must follow the decline in real yields. Real yields are falling because the market's implicit expectation for real growth is falling. Back in the year 2000 you could buy 10-yr TIPS with a 4% real yield because the market thought the economy was going to be going gangbusters forever; real yields on TIPS had to compete with the market's very bullish expectations for real economic growth.
Today, of course, things are just the opposite. Real yields are now negative, and that means the market has almost no hope for any meaningful economic growth for as far as the eye can see. Why buy 10-yr TIPS with a negative real yield (thus ensuring you will lose purchasing power with your investment, since the total return on TIPS will be less than the rate of inflation) when you could buy an equity index fund and gain exposure to the rise in corporate profits which should be at least equal to the increase in nominal GDP over time? You would be indifferent to these two choices only if you held out no hope for there being any real growth over the next 10 years. Put another way, it's as if the market is saying that since the risk of big losses on everything is huge (e.g. there may be a global depression around the corner), then risk-free TIPS which will deliver a guaranteed real loss are better than investing in anything else because at least you know that with TIPS your real loss will be limited.
If that's not a pessimistic market, I don't know what is. But maybe it's just the case that Europeans are panicking en masse, and they will pay any price for a security backed by the U.S. government. Even so, TIPS and Treasuries are priced to something like a depression. This is a replay of sorts of what we saw at the end of 2008, only this time the market is not expecting any deflation; worrying about deflation now doesn't make sense when Greece might default and the euro might disappear, and maybe confidence in currencies collapses and that all leads of course to inflation.
So: anyone who buys TIPS and Treasuries today is effectively endorsing the view that a deep recession or depression—with average inflation—is the most likely outcome.
If you think that view is too pessimistic, then that effectively makes you an optimist.
Posted by Scott Grannis at 9:49 AM