Monday, July 23, 2012

The message of TIPS: extremely weak growth ahead


If you had been stranded on a desert island for the past 10 years and the first thing you saw upon returning to civilization was the chart above, you would most likely figure that dollar inflation must be very high. Why? Because with the real yield on TIPS at its lowest level ever, and firmly in negative territory, you would know that the price of TIPS was at a record high level; and from there it would follow that if investors were willing to pay an unprecedented price for TIPS, then the inflation protection afforded by TIPS must be in very high demand, and therefore inflation must be very high and/or threatening to be very high.

But you would be wrong.



As these two charts show, the expected rate of inflation that is priced into TIPS and Treasuries is relatively low and very normal. The top chart shows the break-even expected rate of inflation over the next 10 years, and it is the difference between the nominal yield on 10-yr Treasuries and the real yield on 10-yr TIPS. The bottom chart shows the 5-yr, 5-yr forward expected rate of inflation, as derived from the pricing of 5- and 10-yr Treasuries and TIPS, and as calculated by Bloomberg. This measure is also the Fed's preferred measure of inflation expectations, and it reflects what investors expect inflation to average over the period 2017 through 2022. The 10-yr expected rate of inflation is now 2.12%, and the forward expected inflation rate is 2.65%. Both compare very favorably to past inflation: the CPI has risen at a compound rate of 2.6% over the past 2 years, 2.0% over the past 5 years, and 2.4% over the past 10 years. Nothing unusual at all about these numbers.

So if the real yield on 10-yr TIPS is at amazingly low levels, but inflation expectations are very normal, what then does the top chart tell us? Actually, it tells us nothing, since to fully understand the message of TIPS pricing you have to also know the price of Treasuries of comparable maturity. That's what the second and third charts in the post show. If TIPS are extremely expensive, but inflation expectations are normal, then the real message is that interest rates in general (both real and nominal) are extremely low. And why are interest rates in general extremely low? The only logical answer is that investors believe that the outlook for the future is very weak growth and average inflation for as far as the eye can see. Very weak growth, as in the weakest growth we've seen on average in my lifetime.


So TIPS aren't really saying anything unusual about the outlook for inflation, but they are saying that the outlook for growth is dismal. Investors are buying TIPS with the full knowledge that they are going to give up purchasing power (as a direct consequence of negative real yields) in the future in exchange for the default-free nature of TIPS (with the exception of TIPS maturing more than 20 years from now, since those real yields are still marginally positive, as seen in the chart above). You buy TIPS today because you figure you would rather lose purchasing for sure, rather than risk losing even more by buying virtually anything else, or even by just holding on to cash or currency.

The message of TIPS is that the market has an extremely pessimistic outlook for the future: pessimism rules. Which of course means that you don't have to be very optimistic about the future to be a bull these days.

UPDATE: I should add that I continue to expect the economy to grow, albeit at a relatively slow pace. Although this would leave the unemployment rate very high, and jobs growth relatively low, I believe my outlook places me well to the optimistic side of the dismal expectations built into current market prices.

Plus, my comment from below bears repeating here: "If the high prices of TIPS reflected huge demand for inflation protection, then Treasury prices would have to be much lower, and the spread between TIPS and Treasury yields would have to be much higher. In other words, we would have to see relatively high inflation expectations if the demand for inflation protection were relatively high. But that's not the case.

Moreover, the extremely low level of all interest rates, coupled with inflation expectations that are simply average, can only be intrepreted to mean that the bond market is effectively expectating economic growth to be extraordinarily weak for as far as the eye can see. Rates are low because the economy is expected to be very weak, and the market rationally expects that very weak growth will force the Fed to keep rates very low for a long time.

12 comments:

Dr William J McKibbin said...

TIPS are simply providing more evidence of economic depression -- the other leading indicators are the long-term decline in US real working wages, the long-term decline in US home values, and the long-term decline in the US employment to population ratio -- all evidence from the bond markets is horrific -- folks, this is what depression looks like -- now would be a good time to blow up California using the expanding Main Street depression as a smoke screen -- a good first step would be to end public education in California as an example for the rest of the nation -- a good second step would be to end public pensions and require that those who rely upon public pension instead apply for Social Security stipends -- we need to see real change in California that provides the rest of the US with a glimpse of the economic reforms and horrors to come...

Pragmatic Investor said...

US poverty rate is at almost 50 year high. For someone as blindly optimistic as you are with a horrible economic forecast record, you really live in a different world. Back in 2010, 2011, you were laughing at Pimco's "new normal" concept. Who's been proven wrong now?


http://finance.yahoo.com/blogs/daily-ticker/u-poverty-hit-highest-level-40-years-165914572.html

Chris said...

Couldn't the rise in prices of TIPS simply be people looking to protect against coming inflation? Not necessarily inflation caused by economic activity, but caused by the gov't printing such massive amounts of currency lately?

Scott Grannis said...

Chris: if the high prices of TIPS reflected huge demand for inflation protection, then Treasury prices would have to be much lower, and the spread between TIPS and Treasury yields would have to be much higher. In other words, we would have to see relatively high inflation expectations if the demand for inflation protection were relatively high. But that's not the case.

NormanB said...

GDP growth has already been awful. Japan hasn't had real GDP for the last 22 years. Using 2013 estimates Europe will have a 9 year zeron growth rate; using the same criteria, the US will have 1.3% per year. But to say that the people buying TIPs are actually reflecting future GDP growth isn't in any way their bet on GDP because TIPs aren't a bet on GDP they are a bet on inflation even though GDP may be bad for however many more years. Its just a coincidence.

Buying TIPs at a guaranteeed negative real yield reflects how much protection they want from inflation because that's all that TIPs do, protect from inflation. That doesn't mean they'll be correct. They may be screwing themselves. Nevertheless, they believe in an ultra strong manner that inflation is going to go so high that they want protection.

The dumb thing here is that the Treasury isn't providing tons of TIPs to the market. Could it be that the Treasury believes, too, that inflation will skyrocket?

Whatever is going on it ain't normal and anyone who goes along with past history of economic indicators, etc probably isn't taking everything into account. Unfortunately for me, i'm just worried and don't have a clue, either. But something from outerspace has hit the financial markets and worldwide economies. We have no history to go on.

Benjamin said...

I wonder if in Japan pundits have been worrying about inflation and slow growth for the last 20 years.

Actually, Japan made a number of structural reforms n the last 20 years, altering the face of their retailing environment and obliterating the lifetime employment concept. They still have pathetic growth and near perma-recession. They have whipped inflation; indeed for most of the last 20 years they have had mild deflation. Interestingly, a mainland China monetary authority recently referred to deflation as "poisonous." They are growing in China.

For what it is worth, the Cleveland Fed pegs inflationary expectations at record lows, I think at 1.3 or about.

Investors may b right about USA growth prospects, if the Fed does not change its course. It appears they will asphyxiate the economy in their worship of extremely low reported inflation rates and aversion to "unconventional: policies, such as QE.

The twilight on an empire? Possibly, and, as usual, the wounds will be self-inflicted.

NormanB said...

Scott Grannis said...
Chris: if the high prices of TIPS reflected huge demand for inflation protection, then Treasury prices would have to be much lower, and the spread between TIPS and Treasury yields would have to be much higher. In other words, we would have to see relatively high inflation expectations if the demand for inflation protection were relatively high. But that's not the case.

I think what is misssing is that Scott thinks the Treasury market is a free market; its not. First, we have the FRB driving down long rates with purchases of these notes/bonds independent need other than to control the market. Secondly, we have the Chinese running huge Current Account Surpluses which effectively are another form of capital influx that is artifical (ie, non-real economic decision making).

The TIP market is a real market; the Treasury market isn't.

randy said...

Benjamin –

Japan is a completely different animal. Deflation there is primarily the result of lower GDP growth and productivity, which is primarily the result of demographics. Aging wealthy don't have demand for things the way young families with growing incomes do. It's that simple. There is just materially fewer consumers with rising incomes to fuel demand. Monetary policy cannot change that.

In the US, population continues to grow of course, but we have some of the same risk due to lack of real median wage growth. That's where the "growing divide" between the rich and non-rich should start to matter, to the rich – but that message seems lost in politics.

In any event, blaming Japanese deflation on monetary policy and ignoring the rest of the story reduces the credibility of your arguments.

Scott Grannis said...

NormanB said "I think what is misssing is that Scott thinks the Treasury market is a free market; its not."

Consider my reasons for believing it is a free market: 1) the Fed is no longer buying Treasuries, except to replace those that are maturing, 2) the Fed bought only about 10% of the Treasuries held by the public, not nearly enough to significantly influence the price of all the rest of the Treasury market and the many tens of trillions of bonds that are priced off of Treasuries, 3) the yield on Treasury bonds out to 10 years is mathematically driven by the market's perception of the future course of the Fed funds rate (you can arbitrage this if you think the market is wrong), 4) yields have been moving up and down with the economic news in predictable fashion, not as a result of Fed purchases, 5) other developed countries have yields that are substantially similar to Treasury yields, 6) all developed countries seem to be suffering from the same growth malaise as the US, leading the market to expect easy central bank policy for many years and thus very low yields on sovereign debt. In short, I see no evidence of price distortion in the Treasury market.

A thought experiment: if the market started to raise its estimate of US growth over the next few years, would Treasury yields rise, or would they remain low until the Fed started to reverse its QE purchases? I would bet strongly that yields would rise regardless of what the Fed did in response to stronger growth.

NormanB said...

To Scott Grannis:

Your analysis has already sparked a lot of thoughts about this issue for me and this last one, "Consider my reasons...", will be deeply considered, also. Thanks for all of this.

djakel said...

I agree with Scott. The Fed cannot control the bond market. It is too large. Demand for high quality bonds is great because all alternative investments are deemed excessively risky in a deflationary environment.

The bond vigilantes are telling us we should be more concerned about deflation than inflation.

Dr William J McKibbin said...

Someone asked me why I believe a US recovery is unlikely in the coming years -- my answer is simple -- a US economic recovery is impossible without inflation, and given that the Fed (and ECB) are committed to near zero inflation, I am betting on no recovery in the coming years -- more at:

http://bit.ly/QEJp1w

Betting on future stagnation and/or depression gets easier when you begin accept the word of people like Dr Bernanke -- Scott and the austerity brotherhood are getting their way -- austerity is here -- and you can take that to the bank...