Wednesday, July 7, 2010

TIPS prices likely to fall

TIPS prices most likely peaked a week ago, and if the economy avoids a double-dip recession, as I think it will, then TIPS prices are likely to decline further, but not significantly.

This chart shows the real yield on 10-yr TIPS, and it is changes in this yield that affect the market price of TIPS (inversely). I've added my subjective estimate of valuation bands to the chart. When real yields are below 1.5% I consider TIPS to be expensive, and I would note that yields have yet to drop below 1%. I think we're likely to see real yields drift up by another 50 bps, which would imply a roughly 5-6% decline in the typical TIPS fund (e.g., TIP). I don't expect TIPS to revisit "cheap" territory in the foreseeable future, since that would only occur if the Fed started to tighten monetary policy in earnest, and/or if the economy started booming.

This is not a strong "sell" recommendation on TIPS, since I think they still make sense for those who want some conservative long-term protection against rising inflation.

There are two ways to make money on TIPS: through price appreciation that is driven by lower real yields, or through rising inflation, since the notional value of TIPS is adjusted upwards by the change in the CPI. It's the first of these that is not likely to work going forward, but the latter still holds potential.

Full disclosure: I am long TIPS and TIP as of this writing.

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