Wednesday, May 20, 2009

TIPS update

One of the big stories this year—and one of the least reported—has been the disappearance of deflation risk. That is highlighted in the first chart here, in the area circled, which shows how the market's expectation of future inflation has risen. (Inflation expectations are calculated by subtracting the real yield on TIPS from the nominal yield on Treasuries of similar maturity.)

At the end of last year the bond market was expecting to see roughly five years of deflation, followed by 5 years of modest inflation, adding up to almost a zero net change in the price level over the subsequent 10 years. Just five months later, the bond market now expects inflation to average about 1.1% a year for the next 5 years, and 1.7% a year for the next 10 years. While this marks a pretty dramatic shift in expectations, the inflation discounted by bond prices today is still lower than it has been for the past 5 years, and lower than the inflation registered in any 10-year period since 1965.

Rising inflation expectations are also evident in the steepening of the yield curve. Despite the Fed's promise to buy up to $300 billion of Treasury bonds, T-bond yields have risen steadily this year even as short-term rates have hovered near zero. A rational investor would fully expect significant Fed purchases of T-bonds to result in higher bond yields, since those same purchases would increase the risk of higher inflation (i.e., debt monetization is a direct source of inflation). One of the Fed's own economists supports that view in a recent paper published by the St. Louis Fed. (It would appear that freedom of speech is still alive and well at the Fed, since the author of the paper directly questions Bernanke's belief that Fed bond purchases can lower bond yields.)

The second chart shows the level of real yields on TIPS, and suggests that at today's prices TIPS are fairly valued. I would not expect to see real yields decline much further, even if inflation expectations continued to rise, because I think that higher inflation expectations will be expressed primarily in rising nominal yields on Treasuries. If I'm correct, then the buyer of TIPS should not expect to see their price rise by very much, if at all; the benefits to owning TIPS will be realized primarily by a rising income stream if inflation proves to be higher than the market now expects.

I would be the first one to caution that rising inflation is not a good thing, but what we have seen so far this year—deflation expectations being replaced by modest inflation expectations—is a good thing I think. Reasonable men could argue about whether deflation is worse than inflation, but I think most would agree with me that it is better to have 1.7% inflation going forward than it is to have five years of deflation. That's particularly important these days, in view of the debt burdens that are weighing on so many people. Deflation compounds those burdens, since it makes acquiring the dollars to pay the debt harder, and it erodes the value of the assets and income streams that collateralize the debt.

Note that I'm not trying to argue that more inflation is going to result in more economic growth. Indeed, I think that the past decade of erratic monetary policy has contributed significantly to reduce the prospects for U.S. growth. A return to higher inflation means the return of speculation (of which there are already some hints in the commodities markets), and that runs contrary to the investment that is needed to produce lasting gains in productivity, which in turn is the only thing that can give us rising living standards. For now, it's best to focus on the positives that accompany vanishing deflation risk. Worrying about the consequences of rising inflation is a task for another day.

On that latter score, I would note the recent weakness in the dollar and the renewed upturn in gold prices, coupled with ongoing gains in commodity prices and a steeper yield curve. These are all portents of rising inflation pressures. Whether the Fed acts in a timely fashion to offset these pressures is going to be very important to how strong the recovery is going to be. If the Fed stays too easy for too long we will see a return of asset price bubbles and growth will be tepid. If the Fed tightens as necessary, confidence in the future will be strong and confidence in the dollar will contribute to a healthy investment climate, and that in turn will underwrite a bright future for the U.S. economy.

Bottom line: vanishing deflation risk brightens the outlook appreciably, but rising inflation risk means we shouldn't get overly excited just yet.

Full disclosure: I am long TIP and TIPS, and short T-bonds (via a long position in TBT), at the time of this writing.


seekingtraceevidence said...

A great set of charts. I prefer to use the Real GDP long term trend + the 12mo trimmed mean PCE to arrive at the rate that the 10yr should trade. This value today is ~5.5%. The 10yr Tr. yield is still too low.

Scott Grannis said...

No argument here--Treasury yields are too low. They only make sense if you really believe that growth will be miserably low going forward, and/or inflation will be very low forever.

Unknown said...

Great timing on the post given the big selloff over the past couple days.

I don't think it is that hard to envision a new, low growth future though, thus partially justifiying today's low level of yields.

I'm curious as to how you arrive at your rich/cheap TIPS valuation?

Great blog BTW.

Scott said...

I think the evidence you present is fairly compelling. The question then is will the Fed have the nerve to reverse its stimulative policies in time to avoid high inflation.

pwm76 said...

I can't argue that inflationary risks are very large. But for now, there is huge slack in capacity utilization, nearly double digit unemployment, a housing market that has a considerable way to fall, and a substantial balance sheet recession still in the early stages. This is all deflationary. I would argue that the rise in inflation expectations, if they raise interest rates significantlly, can also exert a deflationary force.

Is your inflation argument based primarily on the deficit/printing nexus, or do you have other scenarios in mind? Dollar risk is critical in my mind, but are you expecting an increase in velocity and a continued narrowing of spreads? To rephrase: how (and when) do you expect inflation realities to catch up with expectations?

I just discovered your blog. Great stuff.

Scott Grannis said...

twostepp: I think there are only two things that would push real yields higher: a significant Fed tightening and/or a significant pickup in growth. The Fed tightening would probably occur after the pickup in growth.

The valuation bands are something I came up with many years ago at Wamco. The reasoning is rather long, and probably requires its own post. The short answer is that when real yields get above 2.6%, then TIPS become nominal GDP bonds, and as such they begin to compete with equities on a risk/reward basis.

Scott Grannis said...

Paul W: if you go back to earlier posts, you'll see I have often addressed this issue. The theory that economic slack causes inflation to fall is not something I believe in. I think inflation is a purely monetary phenomenon. (If lots of slack were deflationary, why then did Argentina have triple digit inflation during an extended and deep recession in the 1980s?) Those who believe that slack is tied to inflation also believe in the Phillips Curve, and that has been disproved by quite a few people, including some Fed economists. They also make the mistake of assuming correlation means causation. Inflation has almost always declined after a recession, but that's because almost every recession was the result of a significant tightening of monetary policy.

Scott Grannis said...

Scott: I've discussed this issue in earlier posts. The short answer is that I think the odds, and the political realities of today, favor the Fed erring on the side of ease, and thus staying too easy for too long. We've been on a monetary roller coaster for over a decade, and the ride hasn't finished yet.

pwm76 said...

Thanks for the clarification. I will read your other posts.

Now that you are retired and investing for your own accounts, do you find TIPS less compelling because of their tax features? Given the "phantom tax", they will become a negative cash flow asset in a high inflation environment if not tax sheltered. Even if held in your IRA(non-ROTH), TIPS would not necessarily preserve purchasing power on an after tax basis in a high inflation scenario, given your marginal tax bracket as a HNW resident of California.

I do understand TIPS would be attractive relative to other investments and also as a tactical investment. I'm just wondering how you have calibrated your strategy to your tax situation?

Scott Grannis said...

If you buy TIPS bonds in a taxable account then you do have a negative cash flow situation, because the inflation part of the yield on TIPS is paid via accrual (the principal is adjusted upwards), and this is taxed like OID. But if held in a tax exempt account (IRA, etc) you don't have this problem. The total yield will be the real yield plus inflation minus tax, just like any other bond.

I think most small investors are better off investing in TIPS via one of the ETF funds (Vanguard has one, and Barclays has one, TIP). These pay regular dividends that equate to the total yield, and I believe are treated as income for tax purposes. Transaction costs for ETFs are much lower than for TIPS also. Buying and selling TIPS at the retail level is almost prohibitively expensive.

I don't understand why you think TIPS would be unattractive in a high inflation environment because of taxes. Just think of TIPS as being a bond whose coupon payment rises as inflation rises. Taxes are a problem for all bonds, and they will defeat the purchasing power protection of TIPS even with 3% inflation. 1.5% real yield plus 3% inflation minus 1.8% in tax (40% rate) leaves 2.7%. Taxes are a killer for lots of things unfortunately.

TIPS are not the most attractive investment in the world, but I do think they are probably the best choice for money that is meant to be safe, since the big risk that seems to be ignored by the bond market is inflation. They trump Treasury bonds, and are much better than holding cash for an extended period, I believe.

pwm76 said...

I think we agree, but are evaluating TIPS from the standpoint of different objectives. My day job is working in a family office where our performance benchmark is after-tax inflation-adjusted absolute return focused, measured on long horizons. TIPS were an overweight for us when real interest rates were higher and the deficit scenario less dire. However, late last year we looked at a manager whose strategy is to enter into CPI swaps at the 15 year part of the swap curve, using 15 year zero coupon muni bonds for collateral. The intended result is leveraged tax efficient inflation protection. We have also looked at gold, which has a high correlation with the strategy, but without the counterparty, credit, and interest rate risk.

Your idea about using the TIPS ETF is a good one. Buy and hold retail investors can also buy TIPS through Treasury Direct at zero cost. To do this in an IRA, they would need to open an IRA checking account.

Are you currently favoring a certain part of the TIPS curve?

Scott Grannis said...

If I had to choose, I'd go with the 10-year.

Unknown said...

Introduced to your blog by Across the Curve and enjoy reading your economic insights. I note from your profile that you worked at a fixed income firm. I help manage fixed income accounts for a small family office and we are looking for a fee based financial advisor who can assist with US/International fixed income advice, with particular emphasis on corporate fixed income. Might you have any suggestions? Thank you.

Scott Grannis said...

Andre: I'm afraid I don't know of anyone I could recommend. I dealt mostly with large institutional accounts and the consultants that service them.