Inflation expectations continue to fall as seen in the spread between Treasuries without inflation protection and those that do.
Is it any wonder that the Fed is still worried about deflation?
The real inflation adjusted yield of 5-Year TIPS is now scraping along the 0% floor.
The real inflation adjusted yield of the 10-Year TIPS is at a new low.
The real inflation adjusted yield of the 20-Year TIPS is at a new low.
A common question that I see asked on message boards is how low the real yield of TIPS can really go.
Treasury Marketable Securities Tender Instructions (pdf)
Note About TIPS: Should the accepted auction yield be 0% or less, the security will not have regular semiannual interest payments. The yield will be adjusted for inflation throughout its lifetime, thus posting changes at maturity (or sale). In this case, where the accepted auction yield is 0% or less, the interest rate will automatically be set at 0% (never anything lower) for all buyers.
TIPS did not exist in the 1970s. Real yields on Treasuries without inflation protection did turn negative. Here's the question of the day. Did bond investors willingly accept a negative real return though? I tend to think that they didn't. Inflation just sneaked up on them. So how low can TIPS real yields sustainably go? I really don't know. 0% would seem to be the floor though.
I should also mention that if we slide into an ongoing deflationary mess that the real yield of TIPS (even with a stated real yield of 0%) would be positive. That's because TIPS do offer some deflation protection. You are guaranteed to get your original principal back at maturity if you buy and hold for the full duration of the bond. This effect can and is distorting the inflation expectations in the first chart.
Here's an article on that. He does a good job of explaining why this is so.
Beware of the TIPS Spread in Deflationary Times
But this analysis assigns no value to the TIPS' guaranty of repayment at par. When deflation becomes a serious possibility – i.e., when investors take that possibility into account in their decision making – the TIPS spread is distorted by an upward bias in the price of the TIPS, which makes the spread an unreliable measure of the mood of the market.
I would add another factor that is often missing from TIPS spread analysis.
Those who are absolutely convinced that deflation is coming and who are looking for an excellent way to play it would no doubt buy Treasuries without inflation protection.
Those who are absolutely convinced that serious inflation is coming and who are looking for an excellent way to play it would not be buying Treasuries with inflation protection though. They'd be buying hard assets instead.
TIPS should not be considered the opposite of Treasuries without inflation protection. TIPS are dollar denominated assets. They are at risk during periods of extreme hyperinflation, if only due to the incredible potential tax burden. Unlike hard assets, their inflationary gains are taxed each and every year if held outside a retirement account.
I am a big fan of TIPS (much of my nest egg sits in them), but they are hardly risk free.
Source Data:
FRB: Selected Interest Rates
U.S. Treasury: Daily Treasury Yield Curve
Mark, thanks for posting at Calculated Risk (just saw some of your posts there while browsing tonight).
ReplyDeleteI have two comments regarding the TIPS:
First, not everyone is absolutely convinced that deflation is imminent, nor is everyone convinced that inflation is imminent. But many are convinced that we're going to have one or the other, but are just not sure which, as that appears to be a political choice. For those people, TIPS until recently made a decent "safe either way" option, particularly for tax-protected accounts.
Second, I think it's a serious flaw in Fed policymaking to assume that the TIPS and Treasuries markets are efficient enough to produce a meaningful "inflation expectations" measure through the relative yields. One of the great lessons of the 2008 crash is that modern portfolio theory and the efficient markets hypothesis are both deeply flawed. I suspect it would be very interesting to plot your "TIPS/Treasuries Inflation Expectations" chart against actual 5, 7- and 10-year CPI growth, and see how accurate the metric has(n't) been! (For instance, in 2003 the implied 5/7/10 year inflation expectation was about 1.5%/year, and the actual 5/7 year inflation was 2.5-3.0%. Similarly, in 2008 the implied inflation swung from 2.5% to -1% within a few months, and of course most of that range will prove in a few years to have been grossly wrong.
For my part, I find the TIPS yield alone to be very provocative. Bonds historically are expected to return 2-3% above inflation. So the current 10-, 20- and 30-year TIPS yields of 0.7-1.5% could be taken, in and of themselves, to imply a negative inflation rate. Alternatively, the 0% yield on the 5-year (and the other anomalously low yields) could be seen as implying that other asset classes look so overpriced (or corrupt and unappealing?) as to make even a 5 year zero real return rate look attractive!
Or maybe it just means that Treasury needs to issue more TIPS relative to Treasuries, to bring supply back in line with demand! In that mindset, one can take the "implied inflation expectations" with a grain of salt, since Treasury controls the relative supply and can therefore radically influence the yield spread! (The U.S. recently tripled the annual issuance of Treasuries... and the Fed is in QE mode... so what else would one expect but low real TIPS yields?)
A copy of this comment (slightly edited to make it a post) will be on my blog as well, http://i4sg.com
Would love to swap links if you're interested!
Widsom Seeker,
ReplyDeleteWould love to swap links if you're interested!
After skimming a few of your most recent posts, I have added your blog to my blog list. I intend to read more of what you have to say in the coming days.
First, not everyone is absolutely convinced that deflation is imminent, nor is everyone convinced that inflation is imminent. But many are convinced that we're going to have one or the other, but are just not sure which, as that appears to be a political choice. For those people, TIPS until recently made a decent "safe either way" option, particularly for tax-protected accounts.
That perfectly describes me. Most of my nest egg sits in TIPS and I-Bonds. Right or wrong, I'm sitting on more cash than normal right now in hopes that TIPS prices come back down a bit. That's especially true of short-term money that I know I will need and do not wish to risk.
Further, most of my TIPS sit outside a retirement account (although my I-Bonds behave as if they are in a retirement account due to their tax deferred nature). It makes me nervous but I can't say the last 10 years have been unkind. I'd clearly do it all over again, even using the power of hindsight.
The experts are always telling us the dangers of owning TIPS outside a retirement account but seem to have no problem telling us to own fixed income bonds and CDs outside a retirement account. As risky as TIPS are, they are less risky than that. If I someday end up earning 10% and am forced to pay taxes on that 10%, it certainly beats only earning 3% and having that locked in (if inflation is roughly 10%). Paying taxes on higher gains would still be better than simply not having the gains at all.
...as to make even a 5 year zero real return rate look attractive!
I bought the 5-Year TIPS earlier this year directly in the auction. I had to hold my nose when I did it but I'll be darned if wasn't a good move in hindsight. That 0.5% real yield dropped to nothing.
The best reason to own TIPS, at least to me, is that I can have some inflation protection and yet if I am wrong to need that inflation protection then I will do even better than I thought. In other words, I will be rewarded for being wrong. Even in TIPS, inflation never helps me. It can only hurt me.
I liken it to having fire insurance on my house. I never pray for my house to burn. I also never think of it as wasted insurance when my house does not burn.
In theory, the inflation protection that TIPS offer should cost me something. I don't think it costs me as much as it should though.
I don't think enough other investors think of it as insurance. Until recently, I think they saw it as wasted money. I'm not sure what they think of it now. I suspect they see it as a momentum trade. Who really knows though?
The typical gold investor can rationalize each 10% increase in the price. It's just like starting over only from a newer level.
The typical TIPS investor has a harder time rationalizing that though. At some point those 10% increases in price force the real yield into ridiculous quantifiable levels. If held until maturity, we can calculate our expected loss out to the last digit of precision. Go figure.
Funny world.
Wisdom Seeker,
ReplyDeleteI've been reading more of your blog. I like it and I was trying to figure out why I like it.
About the Author and the Blog
“Wisdom Speaker” is a working physical scientist living on the east side of the San Francisco Bay Area. Wisdom Speaker is between 30 and 50 years old and has a top-tier Ph.D. in his field.
That just figures. I've got a degree in physics. I'm clearly more biased in my thinking than I had hoped. Damn. ;)
Great, more scientists!
ReplyDeleteGYSC,
ReplyDeleteWe'll need a theme song! :)
Disgaea 3 opening (With english lyrics)
It's a really good SRPG (strategy role-playing game) on the PS3.
Hi Stag-Mark -
ReplyDeleteThanks for the link; I've added you on my blogroll as well.
I'm not surprised you're also physics trained! Actually, I was also impressed that your taste in blogrolls was so close to mine. I used to do a lot of commenting at Calculated Risk (and before that, at TickerForum), but find lately I need to think-and-write in my own zone. Mish, Exurban Nation and EnergyEcon are also high on my list of writers worth reading, though Mish turned me off a few months ago (at least for a while)...
Like you, I also concluded that having bonds in the taxable account made more sense for me. But my taxable/tax-deferred balance and stock/bond balance leaves me room to put the TIPS in a tax-deferred account... I went with Munis in the taxable account, despite the risks. Like you, I'm buying individual bonds. I like the principal protection from buy-and-hold in the bond space right now, and whenever I look at a bond fund I find myself detesting the huge portion of today's current low interest yields that gets gobbled up as fund fees.
I'm looking forward to reading more here; you're on the nightly survey now... My posting frequency is not always high (real life here is often busy), but I do hope to put out something worth reading from time to time, and hope you continue to agree!
Wisdom Seeker,
ReplyDelete...though Mish turned me off a few months ago (at least for a while)...
Been there, done that. Still waiting on Mish's saltwater car from 2007, lol.
Running a Car on Saltwater
I am not a physicist so I simply do not know. But I am convinced that this is both a new method and not a hoax. Proof that it is not a hoax are the patents given to the process.
He's not a physicist, knows he doesn't know, and yet he is convinced? Had he bothered to look, he would have seen many patents awarded over the years for failed perpetual motion machines.
I was thinking of a new method as well. I call it the ash powered train. It uses pre-burned wood. Still working out the details. Sure to be an economic game changer if I pull it off though, lol. ;)
The full quote:
ReplyDeleteI am not a physicist so I simply do not know. But I am convinced that this is both a new method and not a hoax. Proof that it is not a hoax are the patents given to the process. Here is a list of John Kanzius Patents. As best as I know, not a single patent has ever been erroneously given to the maker of a perpetual motion device.
Patents for Unworkable Devices
Many persons think that you can't get a patent on an unworkable device. That's not true, as these examples show.