January 30, 2007
Earlier this month, we observed that the inflation-indexed Treasury market was priced for the assumption that inflation was a fading threat. But since then, the TIPS market appears to be having second thoughts.
On December 4, a 10-year TIPS yielded a real (inflation-adjusted) yield of 2.11%, according to U.S. Treasury data. As of last night's close, the 10-year TIPS changed hands at 2.50%--the highest since last October.
As our chart below shows, the 10-year TIPS yield has jumped dramatically in recent weeks. Is this a good time to jump in?
Clearly, the bond market generally has become more anxious about inflation's threat in recent weeks. The nominal 10-year Treasury now yields nearly 4.90%, the highest since last August.
As for TIPS, they now offer the following deal: buy a 10-year TIPS and lock in a real yield of 2.50% for the next 10 years. Will that suffice as compensation for any future inflation?
One way to measure your odds success comes by comparing the higher yieldingnominal 10-year to the 10-year TIPS yield. The spread now works out to 2.40%--the highest since last September. What it means is that as long as top-line consumer prices run below 2.40% for the next 10 years, buying a 10-year TIPS in the here and now will fare worse than buying its nominal equivalent.
For perspective, consumer prices advanced by 2.6% in 2006, down from 3.4% the year before. By that measure, it's still a close call as to whether TIPS are the better deal at the moment. Unless you're expecting a material and sustained uptick in inflation in the years ahead from current levels, you're better off with standard Treasuries.
Perhaps some of the rise in TIPS yield of late is tied to worries surrounding tomorrow's FOMC meeting, which will issue its latest decision on the price of money. By most accounts, this will be another non-event and Fed funds will remain steady at 5.25%. Fed funds futures are expecting no less, and for well beyond tomorrow's FOMC confab.
Of course, keeping rates steady if inflation's set to rise could easily stir TIPS buying. That doesn't mean the TIPS buyers are any smarter than the rest of the market, but it may explain the jump in TIPS yield of late.
Nonetheless, the wider market will need more convincing evidence that inflation's still bubbling. The next opportunity for reading inflation's tea leaves comes on February 21, when the Labor Department dispenses the January report on consumer prices.
Meanwhile, the TIPS market is looking anxious. If the anxiety keeps stirring, the real yield on a 10-year TIPS will be too good to pass up, even if inflation's not about to skyrocket. For our money, a jump to a 3.0% yield on a 10-year TIPS would convince us to reconsider the asset class. Meanwhile, we're just lukewarm, but we're watching.
Posted by jp at January 30, 2007 9:30 AM
I'm thinking more in terms of long-term total return rather than yield right now. If the return on Treasury bonds can be expressed as follows:
Rf + I + Rt + Ri = TR
Where Rf is the risk free real rate of return
I is the expected inflation rate
Rt is the term risk premium for your bond
Ri is the inflation risk premium
Then TIPS should be ...
Rf + I + Rt = TR
As long as Ri is positive, the expected return for TIPS is always lower than Treasuries. Now obviously realized I could be greater than expected I, and therefore the TIP winds up outperforming. But I argue that there are better alternatives if you want to bet on higher inflation, such as floating-rate bonds. Unlike TIPS, if the Fed becomes aggressive about fighting inflation, floaters benefit directly. TIPS only benefit if the Fed fails.
Posted by: Tom Graff at February 2, 2007 10:54 AM
Nominal Treasuries do in fact tend to pay a higher yield than TIPS. The question, as always, is how much extra yield in nominals compensates for future inflation risk.
In top-line CPI, energy and food prices will be part of the variables affecting TIPS. So, yes, to a degree, TIPS are a way (an indirect way) of playing energy price trends.
Posted by: Jim PIcerno at January 31, 2007 2:08 PM
My opinion on the TIPS market has always been that investors tend to get paid to take risk, and TIPS remove one of the primary risks of owning bonds: inflation. Therefore, in the long-run, you should be paid more to hold the Treasury.
I also think that since food and energy are the biggest contributors to inflation variance, then a speculative trade on TIPS is in part a bet on oil. Any thoughts on this idea?
Posted by: Tom Graff at January 30, 2007 5:35 PM
Be careful about TIPs as you're exposed to the manipulation of various politicians, statisticians/mathematicians, and civil servants as the recipe/process for cpi changes between the time you purchase and sell/mature your TIPs. Given the uncertainty of cpi formulation, I concur with your recommendation of a 300bp spread to nominal yield of on-the-run 10yrs, as you inferred at the end of your entry.
Posted by: franko at January 30, 2007 9:58 AM