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I see a major problem with the theory behind it though and I want to discuss that here.
If you KNEW severe deflation was coming then there is no better bet than normal treasuries. You lock in 3% say and then watch the value of your investment rise during the deflation. Things get cheaper and yet your money still grows. It is a perfect situation for you. You will get richer. No doubt about it.
If you KNEW severe inflation was coming there are many better bets than TIPS though. When investors get scared of inflation they often run to gold, silver, food, and energy. That's exactly what we are seeing right now. Further, TIPS cannot protect you against hyperinflation. There's simply too much lag and taxes inherent in them for that.
TIPS are therefore a wimpy bet. They are for people such as myself who KNOW that we don't know (and there doesn't seem to be that many of us). I'm scared of inflation but I'm also scared of yet another bubble (commodities?). I KNOW how sure I would have been in the late 1970s stocking up on gold and silver. I also KNOW, using hindsight, that I would have been dead wrong.
So here's my thinking. If you take the difference in yield between TIPS and their non-inflation protected counterparts you do not necessarily have an accurate gauge of inflation expectations. Those who are sure inflation is coming are mostly off hoarding hard goods (which I'm doing too to some degree since there is very little downside in hoarding something you know you will someday use). They aren't buying TIPS. Heck, they probably aren't just hoarding either. They're leveraging up (not me). This casino mentality we have says that "sure things" need massive leverage in order to maximize returns.
Since hard goods have been skyrocketing in price, I therefore submit that inflation expectations are higher than TIPS would suggest. Heck, for all we know some TIPS holders are actually defecting in this game. Let's say you own TIPS and your inflation expectations rise considerably. Do you buy more TIPS or do you sell what you have and start hoarding hard goods in earnest? If you do the latter you will actually be forcing DOWN the derived TIPS/treasury inflation expectations that Bernanke likes to follow. As you are off hoarding hard goods instead, Bernanke will see inflation expectations even more contained. Now that's a conundrum!
So what does this all mean? Well, if inflation expectations are actually much higher than the TIPS derivation implies, that would also mean that TIPS are a much better bargain than the market is expecting (inflation running hotter than expected would mean TIPS would pay more than expected).
Long-term non-inflation protected treasuries are at the very bottom of my wish list. TIPS and I-Bonds are near the top. They meet my personal risk/reward requirements in this environment. Barring hyperinflation, I won't lose my shirt. Everything is risky though. Everything. I've quoted the following in the past and I'll no doubt quote it again.
In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value. If there were, the government would have to make its holding illegal, as was done in the case of gold. If everyone decided, for example, to convert all his bank deposits to silver or copper or any other good, and thereafter declined to accept checks as payment for goods, bank deposits would lose their purchasing power and government-created bank credit would be worthless as a claim on goods. The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves. - Alan Greenspan, 1966
Without further adieu here are some VERY stable inflation expectation charts (starting from the point the credit crisis struck last August, when oil was ~$70 a barrel). It sure looks like an illusion to me, but what do I know?
Source Data:
U.S. Treasury: Daily Treasury Yield Curve Rates
9 comments:
Inflation in needs, deflation in wants of course as far as the FED is concerned that's stability. Therefore inflation expectations are "contained".
I think with the rising real wealth in China, India, Brazil, The Middle East, and Russia along with increasing populations past comparisons are going to be a disappointment as to inflation in the US. We have craped in our nest and our political system is based on ever increasing budget deficits thanks to a currency which has no anchor to stop such foolishness and dollar recycling is going to lead to a crises of major proportions in the not to distant future. Sell the wants, and buy the needs.
Kevin
Suppose that in buying a TIP you are buying both protection against the inflation you expect, plus insurance against unexpected inflation. How could someone else distinguish those two components?
P.S the new issues of the British equivalent of your I-bonds now yield only 0.25% and 0.35% per annum above Retail Price Inflation (for 3 years and 5 years respectively). The previous issues paid 1.35% per annum above RPI. That's quite a drop.
Stag,
That's an astute insight on why TIPS may not be a good measure of actual inflation expectations in today's upside-down economic environment. Inflation has exceeded expectations for five years running - there's a trade.
One important point to consider in the inflation/deflation debate is that both may very well be inflationary on a purchasing power basis to the median American family. If prices rise at 2.5%, but incomes stay flat (as has happened) that's still inflationary to a family budget. Conversely, if CPI deflates at 2%, but unemployment rises and incomes fall by 4% that's also inflationary on a purchasing power basis.
Real income gains are the key imo. Unfortunately, real incomes are like Elvis - they've left the building. The asset inflation game seems to have failed the majority. People are now realizing that their homes will not make them rich. I have a hunch that their 401K's won't return 12% over the long term either.
TIPS don't look wimpy to me.
Kevin,
The wants vs. needs battle continues it seems. The retailers feel the pain in the wants. The consumer feels the pain in the needs. That sure seems to be the trend anyway.
dearieme,
Thanks for the update on real British interest rates. That is quite a drop. Greenspan said there is no safe store of value in a welfare state. In the 2000s, it seems there is no safe store of value in a welfare world.
MAB,
If prices rise at 2.5%, but incomes stay flat (as has happened) that's still inflationary to a family budget.
Yeah. I don't see how it is possible that typical family incomes can keep up with inflation (no matter what inflation is). The incomes of the world's population are out of balance. Once fully balanced, oh oh. Further, my rebalancing scenario does not give billions of people the ability to drive gas guzzling vehicles. I therefore believe that real American wages will be pulled down more than real Chinese wages will be pulled up.
That doesn't make me all that bullish on either us, China, or the rest of the world.
Jim Rogers seems to think China and commodities are sure things. I'd favor commodities over China any day. I don't trust the numbers out of China. I don't trust that they can contain inflation. I don't trust that their country can remain politically stable.
If Rogers is right about the ongoing commodity bull market then I am even more bearish on China. Rising food prices and political stability are not compatible long-term.
China a buy for top investor Jim Rogers
http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/04/28/cnchina128.xml
He said: "All my new money goes to commodities and China. All the panic looks like a bottom.
Just one problem with the story. China was never a sell. He was telling us to buy China at the top too.
MAB,
Inflation has exceeded expectations for five years running - there's a trade.
TIPS should cost more than normal treasuries because they come with insurance (and insurance is never supposed to be free) and are therefore safer.
When relatively free insurance is passed, it leads to the conclusion that one would prefer to gamble.
Welcome to the casino!
Stag,
From your comment above:
I therefore believe that real American wages will be pulled down more than real Chinese wages will be pulled up.
That's a scary thought, but it seems likely. Not a good time to be a typical leveraged American worker with 8K credit card debt, A car payment, zero equity in a depreciating house and 50K in an IRA.
Of course, everything will be fine as long as the stock market appreciates at its historical rate of 11%. No worries.
Let's say you own TIPS and your inflation expectations rise considerably. Do you buy more TIPS or do you sell what you have and start hoarding hard goods in earnest? If you do the latter you will actually be forcing DOWN the derived TIPS/treasury inflation expectations
Doesn't selling TIPS drive the price down, but the yield up?
Is Bernanke comparing yields or prices?
-jus me
jus me,
Yes, selling TIPS would send the price down and would also send the yield up.
Here's an example of how inflation expectations are derived from yields and the consequences of TIPS investors defecting to chase commodities.
Let's say the 10-Year Treasuries yield 4% (no inflation protection).
Let's say the 10-Year TIPS yield 1.5% (over reported inflation).
Inflation expectations would therefore be 2.5% since that is the point at which both investments would be equivalent. You could earn 4% on regular treasuries directly or earn 4% indirectly on TIPS (1.5% yield + 2.5% inflation).
Now let's say TIPS investors sell and the yield rises from 1.5% to 2% (over reported inflation). Let's say they opt to chase commodities instead since they are more sure than ever inflation is on the way.
Meanwhile, let's say investors in normal treasuries are more convinced than ever that deflation is coming. They already have a perfect defense against deflation. There's no need to do anything. Therefore, they do nothing.
The yield on the 10-Year Treasury is still 4% (since nobody sold).
The yield on the 10-Year TIPS rises to 2% (since TIPS investors sold to chase commodities).
Derived inflation expectations are now just 2% vs. the 2.5% previously. In other words, the market expects you to earn 4% directly in treasuries or 4% indirectly in TIPS (2% yield + 2% expected inflation).
TIPS investors (those most likely to fear inflation) defected to chase commodities in this example. The consequences were that the inflation expectations actually dropped.
I'm not saying that this is what is going on. I doubt anyone really knows. It could happen though, especially since TIPS owners are already willing to embrace the inflation idea and therefore would seemingly be inclined to take the next logical step (hoarding hard goods before the next guy does).
My main point here is that normal treasuries (not inflation protected) are a perfect defense for deflation. TIPS are not the opposite though. TIPS are not a perfect defense for inflation. If we hyperinflate, TIPS investors would be financially ruined too. It would just be a slower process.
Therefore, I somewhat heckle the idea that inflation expectations can be fully derived by looking at normal treasuries vs. TIPS. I do calculate the result fairly often out of curiosity, but I don't trust the results to be all that meaningful.
In fact, I'm pretty much counting on the results to be wrong. I like TIPS. I'm not fond of their non-inflation protected counterparts. Maybe that's just me though. If I am wrong and deflation appears, I simply overpaid for a bit of inflation insurance. That's not something I'm going to lose sleep over. I'm more worried that my inflation protection insurance policy (TIPS) isn't strong enough to handle future inflation. The treasury market apparently isn't worried in the slightest though (based on derived inflation expectations in the charts above holding steady). Go figure.
Thanks for the explanation!
- jus me
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