Time for Tips

Deflation is the new buzzword, especially now that the Consumer Price Index has declined or remained flat four months in a row. But that being said, its time to consider intermediate and long-term Treasury Inflation Protected Securities, or TIPS. Its one thing to price in deflation in the near term, but these bonds have priced in zero inflation for the long-term. But given the various stimulus plans currently in place and/or about to be enacted, long-term inflation remains inevitable.

First, take a look at the TIPS "Breakeven" curve. This is simply the nominal yield on a TIPS minus the yield on a traditional Treasury bond with approximately the same maturity. One can infer that this is the "priced in" inflation rate over a given period. All are quoted as of January 9.

5-years: -0.40%
10-years: 0.55%
20-years: 0.103%
30-years: 1.23%

Roughly speaking, if actual CPI comes in higher than those breakeven numbers, the TIPS will outperform the Treasury. If CPI is lower, then the Treasury outperforms.

Might the CPI decline by 0.40% per year for the next 5 years? Or rise by a meager 0.55% for the next 10? Consider the Fed's current tactics.

• Cut the Fed Funds target to basically zero
• Agreed to buy $500 billion in agency MBS
• Agreed to buy $100 billion in GSE debt
• Have or will extend funding to asset-backed securities, commercial paper, among other securities
• Promised to "employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability."

All these things are funded by creating bank reserves. Or as Fed Chairman Bernanke said in 2002, "But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost." That electronic equivalent is the creation of bank reserves. The Fed is printing money.

In a deflationary environment, printing money is the right policy. Had Japan followed a similar path, their generation-long malaise may have been shorter and less severe. But regardless of whether its the right policy, printing money is a highly inexact tool. The Fed will undoubtedly err on the side of creating too much money, as deflation is a much bigger threat. But given this, it is extremely likely that the Fed will wind up creating too much money, and thus create price inflation. To suggest that over a 10-year period, inflation will average zero is to suggest that the Fed will create just enough money to offset the private sector slowdown. That is giving the Fed way too much credit.

The best play here is in longer TIPS, at least 10-years. Short-term, CPI might print very low indeed, which results in a lower realized coupon for the investor. But over the course of the next 3-6 months, the market will start to realize that deflation is going to be a 1 or 2 year phenomenon, followed by a period of elevated inflation. So there is a chance that over 5-years, inflation is (on average) pretty low, but over longer periods, inflation protection will garner a premium.

Long time readers will remember that I've panned TIPS in the past as a quasi-commodity play. I haven't changed that opinion generally, but now I think its clear that both commodities and core inflation should be rising rapidly from here, at least to where final CPI is in the 3's and probably the 4's, with upside much higher.

There are several TIPS funds, including iShares Barclays TIPS Bond (ticker is TIP) and the Western Asset Inflation Management Fund (IMF).

One warning is to beware of the correlation between TIPS and other bets you might have. I mentioned commodities already, but currency plays too might be highly correlated with a TIPS trade.

Disclosure: Long TIPS directly, do not own any TIPS funds.