This chart represents the expected inflation rate as derived from treasuries. If the 10 year nominal treasury is yielding 5% and the 10 year TIPS is yielding 2%, then the expected inflation rate over the next 10 years to make both investments identical would be 3%. I have done nothing to adjust for the higher liquidity of nominal treasuries (since more of them trade) nor have I adjusted for the inflation risk premium (since TIPS would generally be considered safer).
That being said, this is what the market generally thinks inflation will be over the next few years. As can be seen by looking back to mid-2003's 1.25% inflation expectation over the next five years, the market can clearly be horribly wrong. Using the power of hindsight, people should have bought TIPS over their non-inflation protected counterparts back then.
This chart attempts to estimate inflation at various points in the future. For example, the five to seven year prediction is what the market expects inflation to be in the two years starting five years from now. To come up with this graph I merely took the seven year inflation expectation and removed the five year inflation expectation from it. The remainder was the period from five to seven years.
I find it interesting to see the divergence between the three lines in recent months. Hey you hedge funds! You might want to work on arbitraging those gaps and close them a bit, well, unless you think the market can accurately predict that far out.
Here's yet another chart, using data from the 10 and 20 year treasuries as a guide. What it tells me is that people believe inflation will be lower in the next 10 years than it will be in the following 10 years. It might be mostly fear talking and not necessarily reality though. For example, I take insurance on my home because I am fearful it might burn down someday, not because I expect it to. The same might be said of the 20 year non-inflation protected treasuries.
Personally, I'd need a very large premium in order to take on that kind of inflationary risk long-term. You will note that in the fall of 2005 (8/31/05) the market thought it didn't need any risk premium at all (as judged by this chart). It accepted the 20 year non-inflation protected treasury bond at a mere 4.3% (perhaps thinking that the housing market was peaking and deflation was on the way). Two months later (11/4/05) the 20 year non-inflation protected treasury bond paid 4.95% and is still sitting at 4.84% (as of 10/18/07). Oops.
This also explains why it is so hard to be a deflationist. You can be right in theory, but wrong in practice. We might deserve deflation, but our dollar isn't exactly all that healthy these days. In order for deflation to truly work, one has to be able to hoard paper dollars. That's kind of tough when it is being dropped out of helicopters on a regular basis.
I'm trying to be neither an inflationist nor a deflationist. I simply can't seem to make up my mind. So instead, I continue to bet on the slower growth aspect of stagflation (and I've chosen TIPS to do it). I figure that's pretty much a given, until proven otherwise.
See Also:
Extracting implied inflation expectations from TIPS
The “Real” Story About Treasury Inflation-Protected Securities (TIPS)
Source Data:
FRB: Selected Interest Rates
This is not investment advice. If I knew what was going to happen next I wouldn't be attempting to sit on the sidelines.
Hey Mark, is there anyway that you know of to get some kind of approximation of how much foreign money is invested in TIPS?
ReplyDeleteThe one thing that scares the hell out of me about owning any US assetts with the dollar falling right now is capital flight.
Kevin
Kevin,
ReplyDeleteI looked but I can't find much. I can say that the TIPS market is only about 10% of the non-inflation protected market.
I think Warren Buffett makes a pretty good point which may replace your fear with another.
Squanderville vs. Thriftville
http://www.summitglobal.com/acrobat_pdf/warren_buffett_in_fortune_magazine_oct_03.pdf
How often have you seen a comment like this in articles about the U.S. dollar? "Analysts say that what really worries them is that foreigners will start moving out of the dollar."
Next time you see something like that, dismiss it. The fact is that foreigners—as a whole—cannot ditch their dollars.
Indeed, because our trade deficit is constantly putting new dollars into the hands of foreigners, they have to just as constantly increase their U.S. investments.
It's true, of course, that the rest of the world can choose which U.S. assets to hold. They can decide, for example, to sell U.S. bonds to buy U.S. stocks. Or they can make a move into real estate, as the Japanese did in the 1980s.
Moreover, any of those moves, particularly if they are carried out by anxious sellers or buyers, can influence the price of the dollar.
But imagine that the Japanese both want to get out of their U.S. real estate and entirely away from dollar assets.
They can't accomplish that by selling their real estate to Americans, because they will get paid in dollars. And if they sell their real estate to non-Americans-say, the French, for euros—the property will remain in the hands of foreigners. With either kind of sale, the dollar assets held by the rest of the world will not (except for any concurrent shift in the price of the dollar) have changed.
The bottom line is that other nations simply can't disinvest in the U.S. unless they, as a universe, buy more goods and services from us than we buy from them. That state of affairs would be called an American trade surplus, and we don't have one.
So, when thinking that through perhaps it was not a coincidence that my TIPS bond fund did very well during the stock market crash. Dollars that were once invested in stocks had to go somewhere. The value of each dollar might decline, but the dollars themselves cannot flee. They are trapped.
Further, if a trapped dollar becomes worth less, that is inflationary. Since TIPS have inflationary protection, to at least some degree, there are probably worse places to park those dollars.
Just a thought.
Despite China's belief that currency is not the key to the trade imbalance, Fan said China has allowed the yuan to appreciate over the last two years, and said China "should be permitted to have some time to work out all the difficulties" with increasing this flexibility.
ReplyDeleteFan also said the US shares some of the blame for the large trade imbalance, adding that it could be argued that the US helped create its trade deficit by borrowing too much. Fan said this could be seen as "manipulation" of the US dollar, even though many in the US blame China for manipulating the value of the yuan to gain a trade advantage.
"Who printed out the money? Who created this debt?" Fan asked.
The recent dollar drop is also a likely reaction to problems in the subprime mortgage and credit markets in the US, he said. "Actually it [the dollar drop] is the consequence of some policies... of the United States," Fan said.
Along these lines, Fan suggested that the trade imbalance could reflect the use of the US dollar as the world's reserve currency.
"Because the US is a reserve money issuer, the market is able to run higher deficits than others," he said. "So, that means some disequilibrium maybe is the equilibrium of this kind of system, and we may be able to live with it."
http://www.iii.co.uk/news/?type=afxnews&articleid=6346250&action=article
One of these days the dollar won't be the worlds reserve currency is my guess Mark. I think we have abused that privilege and we'll have to pay the piper.
Kevin
One of these days the dollar won't be the worlds reserve currency is my guess Mark. I think we have abused that privilege and we'll have to pay the piper.
ReplyDeleteYeah, we're running our country like a banana republic (trade deficits) so I'd say the risks are high that the currency won't be considered "strong" again any time soon (if ever).