Accrued Interest is a buy-side bond trader for a registered RIA with $1 billion under management.

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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.

Category: BP Cafe, Fixed Income/Interest Rates, Markets

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

6 Responses to “Accrued Interest: Time for Tips”

  1. wally says:

    “But regardless of whether its the right policy, printing money is a highly inexact tool. ”

    And what is the evidence that the government actually knows how to print money? What they have done so far- which they thought was printing – seems to have not exactly worked. Could it be that money is something more than paper and impossible promises and that it cannot be so easily printed? Sure, they can print the markers, just like Vegas can manufacture chips… but that’s not the same thing as commerce, it appears.

  2. Thisson says:

    And who is to say that CPI won’t be intentionally under-reported going forward?

  3. EconWatcher says:

    “But given the various stimulus plans currently in place and/or about to be enacted, long-term inflation remains inevitable.”

    Not necessarily ‘inevitable’. The US is not the only country on the planet with a fiat currency, and all the major countries (Japan, EU, UK, China, Australia, Canada) are busy lowering interest rates toward zero and printing money in perfect Keynesian fashion. For the US to experience inevitable inflation means that all other countries mired in this mess need to reverse course and pursue an Austrian solution…not very likely.

  4. DL says:

    If we do get a roaring bull market in commodities, which could happen next year, investors in TIPS will incur a significant “opportunity cost” by tying up their money in that way.

  5. Bruce N Tennessee says:

    Yes, Econwatcher, I agree with your thinking…see this article about the Fed and the US dollar:

    http://www.bloomberg.com/apps/news?pid=20601085&sid=a8iMJXwBG0N0&refer=europe

    Hildebrand Says SNB Can Intervene in Franc Market

    Well, wait just a second! I was confused. I was reading “dollar” where they had published “franc”….but you know, if you do that, it reads almost exactly like our own US policy…

    …and these are the Swiss! …we are all sub-prime now…

  6. Mike in Nola says:

    I read this and a couple of similar articles a couple of nights ago while trying to decide where to park some IRA cash from maturing CD’s. My concern is the same as Thisson’s. There has been plenty of railing already in this blog about the unreliability of Federal statistics. The Federal government will have a great incentive to underreport CPI because of the savings on Social Security and TIPs. I imagine there are other programs, e.g. VA benefits? that would also provide the same incentives.