TIPS: What know you of ready?

I recommended TIPs vs. nominal bonds in an earlier article. Since that time, the 10-year Treasury is down 4%, while the 10-year TIP is slightly higher. I think TIPs are probably overbought here, and its time to take profits.

First a chart of the breakevens. The blue line is 5-year, the green 10-year and the red 20-years. Breakevens measure the expected future inflation rate as implied by the TIP trading level versus Treasury bonds.



All three have bounced nicely off the lows, with the 10-year breakeven rising from zero to about 1.1%. For a buy and hold investor, that might still seem too low. I still think the Fed's massive expansion of its balance sheet will eventually cause above average inflation reads. But that's probably 1-2 years down the road. Measured CPI inflation could easily be negative, perhaps sharply so, in coming quarters. Will CPI average 1.1% over the next 10-years? Probably not, but it could.

Notice that there hasn't been any confirmation of an impending inflation problem in other markets. Since the 10-year breakeven hit bottom on 11/20 (green line on the chart below), the dollar is basically unchanged (yellow line) while commodity prices have fallen (white line).



If there is really increasing concern about inflation, then the dollar should be weakening and commodity prices should be rising. The fact that these indicators aren't confirming the rise in TIPs breakevens suggests that investors have either become enamored with TIPs, or have abandoned Treasury bonds. If there really were an inflation spike around the corner, we'd have confirming data from other markets.

And it isn't like there has been any encouraging economic news in recent weeks to stoke inflation fears. The key drivers of our current deflation problems is wealth destruction from housing and deleveraging in the financial system. Both these problems continue unabated. We won't get realized inflation until consumers start spending money again. Just look at today's jobs report! Spending will eventually pick-up, but not in the near term.

One can argue that the rise in breakevens has more to do with a sell-off in traditional Treasury bonds than anything else. I think the sell-off in Treasuries is also over done, as investors have become paranoid that increasing Treasury issuance won't be easily absorbed by the market. In a world that is rapidly deleveraging and desperate for safe stores of cash, the U.S. Treasury market will be well-bid. Volitile, due to a lack of market-making,

The bottom line. Eventually inflation will return to the 3% area, and maybe even a good deal higher. But 10-year TIPs are probably fairly valued with breakevens around 1-1.5%, given the fact that the eventual acceleration in prices is a long way off. Given how quickly breakevens have risen, its bound to pull back. Re-establish closer to 0.50%.