TIPS Traders Say Forget It

Oil, Gold Show Inflation; TIPS Traders Say Forget It (Update2)
Jan. 14 (Bloomberg) -- Just because oil trades above $100 a barrel, gold fetches more than $900 an ounce and U.S. consumer prices climb at the fastest rate in two years, now is not the time to buy U.S. government securities protected from inflation.

Just because the sky is dark, the clouds have formed and thunder is heard in the distance, now is not the time to seek shelter.

``There's a distinct possibility we could encounter a severe recession,'' said Seamus Brown, a bond fund manager who helps oversee $8 billion at JPMorgan in New York. ``You would expect inflation to slow and as a result TIPS would probably underperform nominal securities.''

"Probably" and "you would expect" are the keys here. There was a severe recession in 1974. The short-term disinflation was swamped by the inflationary aftermath. It slaughtered nominal securities over the next few years.

TIPS outperformed Treasuries last year amid ``a perfect storm'' that's likely to continue, said John Brynjolfsson, a managing director at Pacific Investment Management Co. The financial crisis stemming from losses on securities tied to subprime mortgages lingers and there's still ``explosive growth'' in emerging markets such as China to drive up commodity prices, he said.

I'm a believer in "perfect storms" these days. Let's not forget the U.S. Dollar losing its purchasing power through a massive trade deficit. There's only so many we can ship in exchange for hard goods before somebody starts to question the value of the fiat paper IOUs. I'm also with Volcker when he calls our current situation "dangerous and intractable."

Demand may already be faltering. The 1.655 percent yield on the Treasury Department's auction of the $8 billion in 10-year TIPS was the lowest since that type of debt was first issued in 1997. Investors submitted bids for 1.90 times the amount sold, the least since April, according to the Treasury.

The article fails to mention that the yield has dropped considerably since then though. Why do you suppose that is? The yield is now just 1.5%. Those who participated (such as myself) in the auction are quite happy as investors rushed in behind them. TIPS also outperformed nominal treasuries today by a wide margin AND did very well despite the stock market rally, for what that's worth. In my book, that's worth quite a lot. That's not exepcted behavior. TIPS have generally been moving counter to the stock market.

In general, I'm especially skeptical of "traders" telling me to "forget" what to do. Why would a trader be looking to protect MY money? While I do not have great expectations for TIPS continuing to reward as they did in 2007, on a relative basis I think they will cause less pain than most (which amounts to the same thing). I could be wrong of course and this is most certainly not investment advice. However, I will say that I am participating in the 20-Year TIPS auction which should be announced later this week. I'll be buying and holding for the full 20-Years. I'm clearly not a short-term trader. It is the long-term future that concerns me most.

As long-term holders of TIPS, we need only suspect that the long-term direction of future real yields is down (that's the most important thing that determines what TIPS are worth). I not only strongly suspect that real yields will fall, but I'm actively betting on it. Real yields were actually negative in the 1970s. Few seem to know/remember that.

Death of Real Yields Perfect Storm

1. Guns AND Butter Governmental Policies
2. Forever War
3. Banana Republic Trade Deficit
4. Banana Republic Rising Income Inequality
5. Banks "Too Big to Fail"
6. Credit Crisis Flight to Quality
7. Slowing Economic Growth Flight to Quality
8. Retiring Baby Boomer Flight To Quality

The 1970s have nothing on us, in my opinion. I don't have to be right on the entire list. Just a few from the list should be good enough.

Further, since I am holding until maturity I will actually do better if I am wrong. It would more than likely mean inflation was not as bad as I feared and/or the economy is doing better than I expected (and those would be VERY good things). I just won't be doing as well as the next person over the next 20 years (who was not buying insurance for inflation protection).

Seeking Antidotes to a Global Plague

Seeking Antidotes to a Global Plague
Round the world, a growing number of jittery investors have lost confidence in the value of paper money and are rushing to get rid of their cheapening dollars, pounds, francs and yen by buying things that they feel have solid and tangible value: land, art, antiques, farm commodities, metals...

Investors seeking tangible value have speculated wildly in wheat...

In practice, the commitment has meant that governments, using the tools of Keynesian economics, react to anything but the briefest and shallowest downturn by increasing spending and pumping up the money supply in order to get the economy moving again....

As prosperity increased, so did people's expectations—for more varied diets, bigger houses, more travel, better education, more skilled medical attention. To get those good things, workers went deeply into debt and counted on rapid wage increases to keep them solvent....

Yet another major inflationary effect of affluence is a matter of sheer numbers: the growing pressure of world demand on the resource base of raw materials. Observes Canadian Economist Carl Beigie, "What is happening is that the fondue pot of the world is being attacked by more people with bigger sticks...."

I should probably mention that this article was written in 1974. It is well worth a read.

Hoarding Thoughts

It is difficult to predict what might happen if the you know what truly did meet up with the fan, but here are some thoughts on what might offer at least some protection. It isn't always easy to figure out what to stockpile. Many items have a shelf-life. For example, I'm not quite sure how much laundry detergent I can hoard. I figure more than several years is probably pushing it. On the other hand, one might think it would do at least as well as shampoo (something I'm also willing to hoard).

Should I be afraid of three-year-old shampoo?
The FDA doesn't require expiration dates on cosmetic products with a shelf life of three years or more.

The following site claims laundry detergent has a one year shelf-life. It also claims pasta has a one year shelf-life. It seems to me that's a bit more conservative than need be, unless your home is experiencing humid 100 degree days on a regular basis.

Surprising Expiration Dates

Here's a site on the other end of the extreme.

STORAGE LIFE OF DRY FOODS

I'm certainly comfortable with 2-3 year old pasta. The Costco pasta I just bought says 2010 is the expiration date. I'm fine with that.

I'm not really preparing for war or actual product shortages, but I'm a buyer of many of the items on the following list anyway (my last big purchase was #84, which has simply been put into storage).

100 Items to Disappear First

I am particularly amused by item #30 ("Toilet Paper, Kleenex, Paper Towels") and its further description at the bottom. I can't seem to get enough of all three of those items.

After awhile, even gold can lose its luster. But there is no luxury in war quite like toilet paper. Its surplus value is greater than gold's.

Toilet paper priced in gold is about the cheapest it has ever been. I joke about that from time to time, but I'm also quite serious.

November 12, 2007
The economics of toilet paper
I was reminded of the commercial recently when Kimberly-Clark announced that it would raise the price of its Cottonelle and Scott bathroom tissues in February. Prices on toilet paper and a number of child-care products will rise between 4% and 7%.

February is almost here. The one year treasury note currently pays 3.04% and you are taxed on your gain. Toilet paper currently pays "between 4% and 7%" (in savings if you buy before the increase) apparently and you are not taxed on your gain.

I am still stagflationary long-term. Further, I'm even beginning to question my short-term deflationary outlook. Go figure.

China's Cunning Plan

China to freeze energy prices
SHANGHAI -- Seeking to allay public discontent over inflation, China's government Wednesday froze prices on gasoline and other energy sources and warned of punishment for hoarding.

Quick question. How does one's inflation expectations change when there are penalties for hoarding? I can't speak for you, but I'd secretly be inclined to hoard even more (secretly of course).

That helped push the year-over-year inflation rate to 6.9% in November, an 11-year high.

This plan was also used successfully by us in the 1970s.

President Nixon Imposes Wage and Price Controls
August 15, 1971. In a move widely applauded by the public and a fair number of (but by no means all) economists, President Nixon imposed wage and price controls. The 90 day freeze was unprecedented in peacetime, but such drastic measures were thought necessary. Inflation had been raging, exceeding 6% briefly in 1970 and persisting above 4% in 1971. By the prevailing historical standards, such inflation rates were thought to be completely intolerable.

When I say the plan was used successfully, I actually mean that it was an absolute and utter failure.

While there were skeptics in August, 1971, there were a great many who thought "temporary" wage and price controls could cure inflation. By 1974, this notion was thoroughly discredited, and attention gradually turned toward a monetary approach to inflation.

Thank You Stock Market Bulls!

I participated in the 10-Year TIPS auction today. I expected a real yield of ~1.56% (the range was 1.56% to 1.59% over the past week).

Today's Auction Results
High Yield: 1.655%

At the very least, I offer my thanks for a well-timed bounce (as seen in the chart below)!



Source Data:
U.S. Treasury Real Yield Curve Rates

Investors Steamed v.2 (Limerick Tribute)

Several weeks ago I heckled analyst Brian Elliott as seen here.

Investors who buy the shares at around $33 will be well rewarded over the next one to three years, Elliott predicted in a research note.

Well, one to three weeks wasn't all that rewarding. The stock is now just $23.

There once was a "Strong Buy" downgraded
"Outperform" on this pig belated
The lipstick's divine
And makes good lookin' swine
But "rewards" have become prorated!

Consistency in the White House (Musical Tribute)

Versus: RAILROADED
Can’t we bring back F.D.R.?

I've been trying to think of something nice to say about our current administration. In 2004, I said President Bush was good for gold. I think I have found something else nice to say: Consistency!

War Policy
1. Shock and Awe (extreme bombing)
2. Mission Accomplished (smoke and mirrors)
3. Quagmire (cold hard reality)

Economic Policy
1. Shock and Awe (extreme stimulus)
2. Mission Accomplished (smoke and mirrors)
3. Quagmire (cold hard "realty")

Mantra: Combining the very best of the 1930s with the very best of the 1970s since 2000!

Special thanks to Marcy Shaffer and all those at Versus for supplying great song parodies!

Stagnation Hits My Blog

As you have no doubt noticed, I've dramatically slowed my posting activity.

I have a head cold and can't seem to find the energy to do many charts, much less summarize the results of my last poll. That's okay though, because with $100 oil I think a lot of people are having a hard time finding the energy!

So here's my 2008 list of general predictions and observations for the New Year (and quite possibly for many, many years into the future).

1. There are too many houses.
2. There are too many banks.
3. There are too many restaurants.
4. There are too many shopping malls.
5. There are too many airlines.
6. The era of cheap food is over.
7. The era of cheap energy is over.
8. Unemployment will continue to climb.
9. The stock market will stagnate (inflation adjusted).
10. Real (inflation adjusted) yields will continue to drop.
11. China will not decouple from us, nor will the rest of the world.
12. Stagflation (slowing growth with above normal inflation) will continue.

I also believe that these trends will continue far longer than most (those who have only been investing in the 1980s and 1990s anyway) think is even remotely possible. That's fairly depressing. Let's hope I'm a pessimist and/or I'm missing some part of the big picture.

Here's what I am doing about it.

I bought (and continue to buy) as many I-Bonds as the government would allow. Based on today's very low real interest rates (and potential risks that inflation might continue to rise), the 1.20% I-Bond is a great relative bargain. It earns an inflation adjusted 1.2% vs. just 1.00% (as of today) on the 5 Year TIPS. It doesn't take a financial wizard to see that the I-Bond is the better choice, especially since it is tax deferred! It also doesn't take a financial wizard to theorize why the government just reduced the maximum amount of I-Bonds you can buy starting this year. I think it is fairly clear that the government is bracing for stagflation (doesn't mean it is necessarily correct though, nor does it mean I am necessarily correct either).

The bulk of my investments are in TIPS (treasury inflation protected securities) and three month treasury bills.

I am reducing some of my three month treasury bill exposure. The real yield now appears to be negative. I'm using that money to participate in:

1. January's 10 Year TIPS auction
2. January's 20 Year TIPS auction
3. Non-perishable hoarding (i.e., Costco purchases)

The auctions don't come around all that often. The real yield on the 20 Year is 1.89% today. It has dropped considerably in the past month. I was hoping the economy would hold together until after the auctions. Santa Claus appears to have left town early and he's taken his rally with him. Oh well! As is the case in any auction, it is generally not a good plan to tell others ahead of time. However, I doubt very much that the "big money" is actively reading my anonymous blog looking for investment advice, lol. Based on how far the yields have already dropped, I'm fairly confident the "big money" continues to make that bet anyway.

This is NOT investment advice. I am simply saying what I plan to do based on the things I believe. The money I will be parking in the 20 Year TIPS is money I intended to use to buy I-Bonds. The government took much of that option away from me. It is also money I will be needing in 20 years. The government has taken yet another step into pushing me into more risky investments (since TIPS are riskier than I-Bonds). The first step was lowering interest rates again to stimulate the economy. Unfortunately, it is not having the desired effect (on me). I'm not "investing" in any of our many housing markets, banks, restaurants, shopping malls, or airlines.

Here's a chart that summarizes my stagflationary thoughts rather well.



In my opinion, that's a classic dead cat bounce. Real yields have been struggling for years. It is the #1 reason I am a stagflationist. I don't see much in the chart to change my mind. If anything, it looks to be getting worse. Real yields turned negative in the 1970s on a great many investments. These paltry real yields of today might be worth salivating over if we continue to muddle through. They can get worse, much worse. It can become a self-fulfilling prophecy. Once hoarding starts (a driver of price inflation), it becomes very difficult to stop the hoarding behavior. Nothing says hoard like earning a negative real interest rate (and then be taxed on the "gain" as well).

The deflationists (such as Mish) keep pointing to the money supply to support their deflationary cases (even as oil rises to $100, gold hits $860, and the year over year CPI breaches 4% even as housing prices decline). If anyone finds out what they are smoking, I'd sure like some. There is a LOT of actual money floating around out there. I'm looking at money supply and all I see is a scary chart. You'd think the government spent 25+ years handing out money for free. That's what I think. In fact, that's exactly what I think. Positive real rates were handed to savers as a reward for not hoarding goods. It was a delaying tactic to temporarily thwart consumer price inflation as we fell off the gold standard.

1990
Government: What are you thinking?
Investor: I'm buying a gallon of gasoline with my dollar.
Government: We'll reward you with another dollar if you don't.
Investor: Okay.

2005
Government: What are you thinking?
Investor: I'm buying a gallon of gasoline with my two dollars.
Government: Here's another dollar! Don't do it!
Investor: Okay.

2007
Government: What are you thinking?
Investor: I've got $3 but can no longer buy a gallon of gasoline.
Government: Can't help you. We printed too many dollars.
Investor: But I need more dollars!
Government: That's some conundrum.
Investor: Well, at least I have $3.
Government: Not quite. You owe tax on the $2 we gave you.

As a saver, I'm heavily inclined to hoard hard goods that I will someday need if there isn't an incentive to stop me. What is the reward to stop the savers from hoarding these days? A taxable 3% return on short-term treasury bills when year over year inflation is over 4% certainly isn't much of a reward. It is a punishment. Why would I hoard paper fiat dollars over toilet paper? Do I think the price of toilet paper is going to suddenly fall in price? I know I will need dollars but I also know I will need toilet paper. I therefore see very little downside (pun intended ;)) in locking in my long-term toilet paper price right now, lol.



I wish to offer thanks to all that have posted comments on my blog. Words cannot express how much it has helped me to be able to bounce my ideas off of you. This is not a long-term goodbye. I will be posting more in the future, especially as conditions change. I just don't feel the need to keep beating a dead horse. Or perhaps the saying should be beating a dead house?

I'm not going to devote my life to watching the economy crumble (if indeed it does). I can say I have little hope for the future. Just look who we put in charge of it two times in a row.

And when somebody builds a new building somebody has got to come and build the building. And when the building expanded it prevented additional opportunities for people to work. - George W. Bush, October 3, 2007

One has a stronger hand when there's more people playing your same cards. - George W. Bush, October 11, 2006

See Also:
Extremely Bad News for I-Bonds!
The Death of Real Yields

Source Data:
Tentative Treasury Auction Dates
U.S. Treasury Real Yield Curve Rates
BLS: Consumer Price Indexes (CPI)
St. Louis Fed: MZM
St. Louis Fed: Population
The Complete Bushisms