April 12, 2006
TIMING IS STILL EVERYTHING
The opportunity to lock in a real, or inflation-adjusted interest rate is one of the great innovations of modern finance. The question of timing one's decision on buying and selling, on the other hand, is subject to all the usual pitfalls regardless of the security in question.
Fortunately, historical context sometimes offers a touch of enlightenment, as illustrated by the recent track record of the 10-year yield on the 10-year inflation-indexed Treasury, or TIPS as they're commonly called. As the chart below illustrates, higher yields have come to those who wait. Or so the last few months suggest.
Buying a 10-year TIPS as of last night's close delivered a real 2.37% yield. That's near the highest in several years. In fact, last Friday's trading closed with a 2.43% TIPS yield, the highest since September 2003. That's a nice improvement over the TIPS yields of under 1.7% as recently as last September.
The question, of course, is whether locking in a real 2.37% yield now is sufficiently enticing for weathering the future. Or, might there be even higher real yields available in the weeks and months ahead?
Given the propensity of interest rates of all stripes to err on the side of rising in recent days and weeks, investors can be forgiven for choosing the waiting game. Indeed, the strategy, such as it is, has worked in the recent past, and there's a case to be made for thinking that upward momentum in the price of money may continue to roll on.
Money market funds are particularly well suited to this game, as yields adjust along with the prevailing monetary winds. And for the moment, such flexibility has its charms. The Fed funds futures market all but expects another 25-basis-point rate hike in Fed funds to 5.0% at the next FOMC meeting in May, based on the May contract. Futures traders are less sure about the June FOMC meeting, judging by that month's contract, although the notion of elevating Fed funds to 5.25% can't yet be dismissed.
In the here and now, the bond market is digesting the recent turmoil that sent nominal yields higher in recent weeks. But the rise in the benchmark 10-year nominal Treasury to just under 5.0% this week has run out of steam. The benchmark bond's yield has slipped for two days straight through yesterday's close. This may be more a reflection of fresh anxiety over various global tensions than a fundamental reassessment of economic prospects. The ongoing news over Iran's nuclear program, along with the latest runnup in oil prices to just under $70 a barrel, has inspired some to opt for a flight to safety in Treasuries. Economic analysis for the moment is out; geopolitical-based pricing is in for the fixed-income set.
The anxiety is spilling over into the stock market, which fell yesterday. In fact, there's more than geopolitical risk afoot. Investors are again struggling with the prospect that higher commodity prices, mainly oil, will elevate inflationary pressures, which in turn would inspire the Fed to keep hiking rates. Such fears may be weighing on equities, although the flight-to-safety has given the bond market a reprieve. Can it last? History suggests otherwise. Eventually, economic fundamentals dominate pricing in the capital markets. In the interim, of course, the capacity for alternative theories driving results is unlimited.
Posted by jp at April 12, 2006 10:16 AM
Considering the assertion that econo-stats from govts running fiat money systems are being gamed (this would comprise the world economy, since nobody has a commodity-linked currency, to my knowledge), one might be inclined to always be in debt, since that way, you are mimicking the condition of the govts who are assuredly going to look after their own situation. To be a lender to said govts, in a manner linked to their own inflation measures is a little too much like putting the fox in charge of the henhouse. Ofcourse, one must be sure to avoid taking on too much debt, and that is another judgement call.
Posted by: franko at April 13, 2006 8:19 AM
The problem with TIPS is that owners are at the beck and call of the BLS and their tortured and ever-evolving measure of inflation - CPI. John Williams at shadowstatistics.com actually calculates CPI as it used to be before the mid 1990's and it is running at 7%. So the yield on TIPS is actually a negative real yield based on this measure. One should only have faith in the "real" yield of US TIPS if they have faith that the government will accurately measure inflation. History suggests one would be better off having faith in a pet rock.
Posted by: James at April 12, 2006 5:07 PM