Thursday, November 19, 2009

TIPS valuation update (2)

This post is a follow up to my post yesterday on TIPS valuations. The purpose of this chart is to show that real yields on TIPS are largely determined/driven by changing expectations for Fed monetary policy. The red line represents the real yield on 5-year TIPS, and the blue line is the market's one-year forward expectation for 3-mo. Libor (as determined by the fourth eurodollar futures contract), minus the current year over year change in the Core PCE deflator. Thus the blue line is a proxy for what the market expects the real Fed funds rate to be in one year.

It is expectations of future Fed tightening or easing that drive TIPS yields, and the logic is simple. If you expect the Fed to be reducing the real Fed funds rate in the future, then your desire to own TIPS increases, because an easier monetary policy increases the risk of rising inflation, and thus increases the demand for TIPS. In the past month or so, the market has sharply reduced its expectation of where the Fed funds rate will be at the end of next year, and this has almost exactly corresponded to a sharp decline in the yield on TIPS. At the same time (though not shown on this chart) the market's 5-year, 5-year forward expectation of inflation has risen sharply. It all ties together.

As a thought experiment, assume that the Fed were to raise the funds rate unexpectedly tomorrow. This would likely cause the market to shift upwards its expectation for the level of the funds rate in one year. According to my model, that would in turn result in a sharp increase in the yield on TIPS, as well as a decline in the market's breakeven inflation expectations. The implications for the Treasury market would be a rise in both nominal and real yields, but with real yields rising more than nominal yields.


piefarmer said...

On 11/18 you closed with the idea that TIPS are cheap relative to treasuries:
"So, while the first chart suggests that TIPS on a standalone basis are relatively expensive at current levels of real yields, they are a risk/reward bargain compared to Treasuries."

In this post (11/19) you suggest TIPS stand to lose the most if the FED were to surprise with a rate hike:
"The implications for the Treasury market would be a rise in both nominal and real yields, but with real yields rising more than nominal yields."

I admit to being easily confused, but these ideas seems incompatible. What am I missing?
Thanks for a great site.

Scott Grannis said...

What you're missing is that TIPS are complex instruments whose total return is dependent on three independent variables: inflation, initial real yield, and ending real yield.

TIPS are a bargain relative to Treasuries because they are priced to the assumption that inflation in the future will be only 2% or so. If inflation is more than that, then TIPS held to maturity will beat a Treasury held to maturity of comparable maturity. TIPS will equal Treasury returns if inflation is 2%. TIPS would only underperform Treasuries in a very low inflation environment, but that seems very unlikely given how accommodative current policy is.

The greatest risk to owning TIPS is a scenario in which the Fed tightens unexpectedly soon and aggressively. Holding period returns that are less than the maturity of TIPS could produce unpleasant results in this case. But since this appears to be a low probability event, then the most likely outcome (in which inflation exceeds 2%) dominates an investor's expectations.