Pulled Into the Deflationary Abyss

TIP vs. Stocks

Long time readers of this blog know that I like TIPS (Treasury Inflation Protected Securities). Much of them I bought directly from the government and will be holding until maturity. Some of my money is in TIP (a fund composed solely of TIPS). I'm certainly taking damage lately, just not as much as some.

As I see it, there are three reasons I'm taking collateral damage (pun intended). They are all somewhat related.

1. Real yields are rising dramatically. The Great Depression saw very high real yields. Buried cash yielded a good 10% as prices were falling at that rate. Deflation does that. These days, we're seeing asset prices fall quite dramatically as well. Oil and other commodities are well off their highs. Housing prices are down significantly. The malls are bracing for a horrible Christmas shopping season. The stock market has been seriously deflating lately. Too bad I couldn't have predicted the stock market meltdown. I was very bearish but I wasn't THAT bearish.

2. There's an unprecedented flight to liquidity/safety. Just look at the VIX. Long-term TIPS are not all that liquid. The market price of them also generally tends to be quite volatile, which is especially true these days. No doubt some are being shaken free from the wild ride.

Inflation Expectations: How the Market Speaks

Second, TIPS yields contain a liquidity premium. While the market for TIPS is growing, it is still relatively small compared to the market for conventional Treasuries. Therefore, to the extent that TIPS are less liquid than Treasuries, investors would demand a liquidity premium for holding TIPS over conventional Treasuries.

3. The concept of "buy and hold" died, at least temporarily. I actually agree with some of the bulls on this one. Babies and bathwater are all the same these days. Everything must go! (Sounds like a Linens 'N Things economy to me.)

The U.S. Treasury's Inflation-Protected Securities : market reactions and policy effects - TIPS

In one sense, these securities should not be as liquid as conventional securities, because the Treasury's target market is the "buy and hold" investor.

I am a "buy and hold" investor. As my TIPS mature, I'll be buying more. My next purchase is planned for January's auction. If I liked TIPS with a 2% real yield, you can bet that I'll like them with a 3% real yield (over reported inflation). I'm not holding my breath that I'll be able to keep getting that rate for the rest of my life though. I think that at some point in the future, people will be kicking themselves for not locking in a rate like that (especially if the government's response to the crisis ends up fueling future inflation). I could be wrong of course. If I am, then the American taxpayers will be kicking themselves for paying me an excessive "safe" rate of return. In fact, they should be especially brutal with the kicks if we actually do enter a 0% inflationary environment (think Japan's deflationary mess) and I'm being paid 3% annually for the privilege.

Once again, this is not investment advice. For one thing, my goals are and have been capital preservation. I don't have a job. I can't afford to take on any additional risk. Investing in the full faith and credit of the United States Government through inflation protected securities, especially these days, is just about as much risk as I can stomach. Trust me on this. I can just barely stomach it. It simply seems somewhat better than many alternatives.