Monday, January 12, 2009

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.


mxq said...

but isn't consumption the match that lights the excess fuel created by monetary policy?

no consumption = no inflation?

In Debt We Trust said...

Why not just short treasuries for greater returns?

Look at the open interest in the 2010 and 2011 TLT far out of the money puts.

steveplace said...

Perhaps getting long TIPS and shorting treasuries could make a trade... thanks for the idea.

PNL4LYFE said...

Two questions about those specific ETFs. First, they both have yields over 6% over the last 12 months. Are these funds designed to return pricipal appreciation? I'm having a hard time figuring out how they can yield so much. Also, according to Bloomberg, TIP last paid a dividend in October. Did it really stop paying, or is this a data issue? Thanks.

Unknown said...

mxq raises a point that's a key debate right now: keynes vs monetarism. It's a short-term/medium-term argument I think: in the medium term, if you have more money and the same amount of stuff, then the stuff will cost more money. And you have a lot more money in the system, not just domestically but globally.

In the short-term we also have collapsing money velocity, so there are near-term constraints on inflation. But unless you think the Fed can perfectly time the punchbowl removal...or if you think somehow they will be early...then TIPS are a great investment here even though they've richened a lot the last month or so. I don't like TIP because the retail investor can't evaluate whether it's fairly valued, and I think new-issue TIPS are expensive because the floors are overvalued.

We discuss inflation and inflation products exclusively on the website of the newly-formed Inflation-Indexed Investing Association. Right now we have a blog; expect to add discussion groups soon. And lots of educational links. , if accrued interest doesn't mind the plug.

John said...

"This is simply the nominal yield on a TIPS minus the yield on a traditional Treasury bond with approximately the same maturity"

that's backwards

Arcturus said...

So if someone buys the TIP ETF, does that give you the longer term exposure that you are talking about?

Unknown said...

Often ignored, but very important in this environment is the embedded option in TIPS. As Michael alludes to, there is value in the floor of TIPS, particularly on-the-run TIPS. This is due to the CPI factor accruing to the principal over the life of the TIPS, and the fact that a TIPS bond will pay par at maturity, even if CPI is negative over its life. Given the impact of the option, an on-the-run TIPS will perform similar to a nominal treasury in a deflationary environment while providing inflation protection if CPI is positive. This best of both worlds situation is clearly not free to the investor, which is why you see such discrepancies between the prices of on-the-run and seasoned TIPS.

John (Ad Orientem) said...

I am a little new to the bond side of investments so this may sound like a silly question. But if we are worried about a spike in inflation down the road (I am), why not invest in bonds denominated in a non US currency? I was thinking something like Euro bonds or Swiss Franc bonds.

All of the gold bugs seem to think that after a couple bars of the hard yellow stuff that Swiss Frans are the next best hedge against inflation.

In Debt We Trust said...


Euroland is in even worse shape than the US. The Euro is a fundamentally flawed currency. It is a union of disjointed economies that lack a common fiscal and monetary policies.

The weakest links in the chain are in the periphery - Greece, Spain, Italy, Ireland, and Portugal. These are spendthrift happy states perpetually in big deficit that are dragging the rest of the Eurozone down w/them.

The Europeans are trying their own quantitative easing experiment but will fail. There is simply not enough demand in the world to soak up all the supply being issued by G7 govts (emerging market govts are a different story as they will continue to attract yield chasers and other risky money).

Conclusion - There is only enough room for 1 Q.E. beast in the world and that is the US.

Accrued Interest said...

I have mixed feelings about the Euro as an investment. On one hand, Tichet seems way behind the curve, way too slow to cut. Which would imply that the euro zone would suffer worse deflation and thus the currency should appreciate.


The euro has a much more hawkish Trichet already priced in, and therefore when he finally comes to his senses, the euro weakens substantially.

But either way, the Yen looks better than either.

John (Ad Orientem) said...

May I assume that no one is warm and fuzzy about Swiss Franc bonds?