Tuesday, October 6, 2009

TIPS update

With gold making new all-time highs ($1042/oz. as I'm writing) and the dollar on the verge of a new low for the year, it's once again time to revisit TIPS. Gold is sending a powerful inflationary signal, yet TIPS continue to be priced for a benign inflation outlook. What gives? I've commented on the issue of bond market complacency before, and this posts revisits the subject from a slightly different perspective.

I was a big fan of TIPS late last year, when expectations of a deep deflation caused their price to collapse and real yields to surge; I thought that the market then was way-overestimating the risk of deflation, and TIPS were therefore very cheap. Since then, real yields have declined and TIPS prices have risen, while deflation risk has almost disappeared. Yet the TIPS market is not even close to getting the inflation jitters. As the first chart shows, the inflation expectations built into 10-year TIPS call for the CPI to average less than 2% a year. That's rather astounding, considering that the CPI has averaged 2.6% for the past 10 years, and monetary policy is currently extraordinarily accommodative. Breakeven inflation expectations for the next 5 years are only about 1.4% per year!

The best explanation I can come up with for why the bond market is so complacent about inflation risk is that the market is assuming that the outlook for U.S. economic growth is abysmal. That adjective might be a bit of an exaggeration, but when 10-year Treasury yields are only 3.25% my first thought is that the market doesn't think nominal GDP growth is likely to exceed 3% for the foreseeable future. (Nominal GDP has averaged 5.1% over the past 20 years, and the 10-year Treasury yield has averaged 5.5%.) By inference, since the Fed has basically sworn to give us positive inflation, that means real growth of 2% or less. And that, in turn, would not be enough to bring unemployment down for a very long time. A few years of 2% growth would leave the country and the electorate extremely frustrated, to put it mildly. It is also the case that the market firmly believes in the Phillips Curve theory of inflation, which holds that a prolonged period of subpar growth would translate into extremely low inflation, no matter how aggressive the Fed tries to be.

So Treasury yields, both real and nominal, are very low because economic growth and inflation expectations are very low. There's simply no other logical explanation in my book.

As the next chart shows, real yields on 10-year TIPS are now trading at the low end of their "fair value" range (as determined by me). This reinforces the argument I've made in recent months that TIPS are no longer a steal. They are however an excellent alternative to holding cash, since cash yields are almost zero, and TIPS are a great vehicle for money that one wants to keep safe from the ravages of inflation. They are also likely to do much better than Treasuries of comparable maturity if and when inflation picks up.

It wouldn't take much of a pickup in inflation for TIPS to pay off handsomely, at least relative to cash or relative to holding regular Treasuries. If inflation picks up up to, say, 4-5% or more, then I would fully expect the demand for TIPS to be quite strong, and that would likely keep real yields on TIPS at least steady, if not push them lower. Meanwhile, stronger-than-expected inflation would undermine the Treasury market, with the result that nominal bond yields could rise significantly from current levels.

A word about risk is probably in order. The main risk to owning TIPS right now is that the Fed might begin to tighten policy sooner than the market expects. The blue line in the next chart is the essentially the market's current expectation for what the real Fed funds rate will be one year from now: about 0%. The market sees very little chance for any meaningful tightening of monetary policy for at least another year or so. The expectation of very low real short-term rates keeps real yields on TIPS very low, just as the expectation of a very low funds rate keeps yields on Treasuries very low. (That's why the red and blue lines track so well.) So if the Fed tightens policy even just a little bit (by raising the funds rate above the level of inflation), that will put upward pressure on TIPS yields and downward pressure on TIPS prices. In short, a tighter-than-expected Fed would means less inflation risk, and that in turn would mean less demand for TIPS and higher TIPS real yields.

If you're looking for more info on TIPS, I've made numerous posts over the past year that you can find by using the search field in the upper left-hand corner of the blog.

Full disclosure: I am long TIPS and TIP at the time of this writing.

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