Wednesday, November 18, 2009

TIPS valuation update

TIPS continue to rise in price (which is shown in this chart as a decline in their real yield to maturity), as demand for their inflation protection increases. This has been the salient feature of the bond market since the beginning of last month: real yields have declined across the board, and they have declined relative to nominal yields of comparable maturity.

This rise in inflation concerns is a somewhat belated response to the revival in inflation itself, as this second chart shows. The year over year decline in the CPI which started late last year, and has dominated the headlines, has masked the 2.7% annualized rise in the index for the year to date, and the 3.5% annualized rise over the past six months. Inflation is alive and well, despite the enormous amount of "slack" in the economy that, according to the Fed's inflation model, should be producing active deflation by now.

The inflation implied by the difference between real yields on TIPS and the nominal yield on Treasuries has risen significantly from its low of late last year (when the market expected CPI inflation to average almost zero over the next 10 years), to now 2.2% over the next 10 years. The 5-year, 5-year forward inflation expectation has risen from 0.7% to 2.7% over the course of this year. By either of these measures, however, TIPS are still priced to future inflation being equal to or less than what it has been so far this year, and well within the range of where it has been in the past 5 or 10 years. In other words, the bond market has not yet begun to price in any increase in inflation beyond the ordinary, despite the enormous expansion of the Fed's balance sheet in the past year, and the Fed's repeated assurances that they will keep short-term interest rates very low for a very long time.

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.


Steve Grannis said...

I attended a conference last week where economist Gary Shilling was a featured speaker. His view is Treasuries are a good buy now. Many people were surprised, having the opinion that Fed liquidity will be overdone and cause inflation to come roaring back. To the contrary, Shilling said he expects our savings rate to increase 1% per year for the next decade (that's right, a double-digit savings rate in the US), which will keep rates low for a long time.

Scott Grannis said...

So is he saying that a high savings rate will keep inflation down, or that it will keep interest rates low, or both? In my experience inflation is by far the dominant influence on Treasury yields. For T-bonds to be a good buy today you have to be supremely confident that inflation will remain very low forever.

I've never seen any strong correlation between savings rates and interest rates. And in any event I think the savings rate can be a very misleading indicator.

piefarmer said...

I share your view, but in case you are interested, you can watch Mr. Shilling's presentation here:

Steve Grannis said...

He was saying the high savings rate would keep inflation down. In fact, it sounded to me like he's expecting deflation for an extended period of time. I'm with you regarding T-bonds, Scott, but I had to at least listen to a guy who called the sub-prime meltdown last year. And I have to say it concerned me to hear him say it might be a good time to sell one's house.

Scott Grannis said...

Gary Shilling has been calling for deflationary death and destruction for as long as I can remember. So he finally got it right last year, but only after 20 years of being wrong. Now he's still stuck in the same rut.