This shows the inflation expectations as derived from the treasury market (comparing nominal treasury yields and inflation adjusted yields of the TIPS market).
Everything seems relatively normal, right? Wrong. Something is very amiss. Why are the inflation expectations for 7 years well below the inflation expectations for 5 years and 10 years?
Since we know the inflation expectations for 5, 7, and 10 years as judged by the "all knowing" treasury market (said somewhat sarcastically), that allows us to calculate the inflation expectations in other time frames within those periods.
What the heck is happening lately? Let's look at the next 5 years as seen in the first chart. That's running at 2.27%. Then, from 5 years to 7 years the market is expecting just 1.92% inflation (as seen in the black line in the chart above). Finally, from 7 years to 10 years the market is expecting 2.87% inflation (as seen in the red line in the chart above).
That's chaos and confusion. It would make no sense for the market to predict such behavior five years out. It has a hard enough time predicting what inflation will be even six months out, much less fine tuning its predictions 5 to 7 years out.
So what is causing it? I believe I have an answer.
Note the hump in the 7-year TIPS. The higher yield on the 7-year TIPS implies fewer investors want it. Why would that be?
There is no 7-year TIPS auction! If we, as individual investors, decide we want to buy TIPS directly from the government we would do so primarily by participating in the 5-year, 10-year, and 20-year TIPS auctions.
That tells me that individual investors are backing up the truck on TIPS and they are doing so directly (cutting out the middle men). That's exactly what I've done for the most part and it appears to be what others are doing.
So what does this mean to us? If we were thinking of buying a combination of 5-year TIPS and 10-year TIPS, we might want to consider buying the 7-year TIPS instead through the secondary markets.
What else does it mean to us?
A new economic phenomenon: Growthcession
The Fed is increasing the frequency, expanding the time horizon and taking a broader view of inflation in its forecasts. It’s doing so in the name of transparency and in hope of managing expectations to better fit its policy prescriptions.
Managing inflation expectations is at least half the battle, and there's a serious risk (based on the TIPS market) the battle might not be going their way.
Growthcession. We may be witnessing the birth of a word — one that might take its place in the economic lexicon alongside the stagflation that defined an era three decades ago. If so, we may have to get used to it.
Yuck.
Yuck is right. I have no great desire to change my name to Growthcessionary Mark. I suspect I'd need therapy (or at the very least, chemotherapy).
See Also:
Inflation Expectations
Source Data:
FRB: Selected Interest Rates
Hi,
ReplyDeleteMaybe you can help me understand something. Inflation-protected mutual funds and ETF's are showing large returns this year.
For example, the Vanguard Inflation-Protected Securities Fund Investor Shares (VIPSX) is up 12.12% YTD Return as of 11/27/2007.
Why are these TIPS funds up over 12% year to date when the underlying TIPS don't return nearly that much?
Thanks!
I'll describe a similar hypothetical example case, since it will be easier to do the math.
ReplyDeleteLet's say one year ago I locked in a 2% real yield on a 10-year inflation protected treasury.
Now let's say the best the market can give me is a 1% real yield.
Since I have a 2% real yield locked in for 9 more years I will earn roughly 9% more over the next nine years than the person who would be buying the 1% real yield right now.
Therefore, my 2% real yielding treasury is worth 9% more right now. That explains 9% of the rise but there is still more. I've also been earning interest for the full year as well. That's another 2% (plus the inflation over the last year).
Owners of TIPS have had a pretty good year, since real yields have come down.
However, should real yields go back up (always a possibility especially if the economy strengthens) this process would play out in reverse.
In other words, if real yields shoot back up you would expect to see fairly significant losses.
The news isn't all bad though, depending on your time frame. If you are planning to hold for the long-term (say 30 years), you should probably root for higher yields now. It would hurt you in the short-term but the higher yields would really help you in the long-term (assuming you continually reinvest the proceeds back into the fund).
TIPS funds are not without their risks. What goes up can easily come back down. One need look no further than today's stock market rally to see the pain inflicted. Further, real interest rates are extremely low. I wish I could say how low they might go. I have no crystal ball.
I vastly prefer I-Bonds at these levels, for what it is worth. You won't be getting 12% gains in a given year due to small fluctuations in real yield, but you also won't experience 12% losses either. I consider I-Bonds by far the safest U.S. treasury you can buy.
Just my opinions of course.
Here are some more of my thoughts on it.
http://illusionofprosperity.blogspot.com/2007/11/features-and-risks-of-treasury.html