December 29, 2008
WELCOME TO PARITY
Deflation is here. The question before the house: How long it will last?
Ideally, it's just passing through, albeit throwing everyone into a temporary tizzy with worries that the U.S. is set to repeat the Japanese experience. Certainly the Federal Reserve is working over time in trying to make sure the disease is short-lived. But for the moment, at least, prices are generally falling, as we've discussed, including here.
The great experiment in trying to keep a sustained case of deflation at bay is upon us. The immediate danger is that consumers and businesses expect deflation to persist. As many studies have shown over the years, along with more than a fair bit of empirical evidence, expectations are critical factors in determining the level of inflation and its cousin, deflation. Once the Fed loses the battle on managing expectations, monetary policy becomes much weaker.
On that note, we must recognize that one measure of expectations, in the form of market prices for expected inflation, is clearly flashing a warning signal. Expected inflation for the next 10 years, based on the spread between nominal and inflation-indexed 10-year Treasuries, was a mere 0.13%, as of December 26, 2008. That's down from nearly 2.6% in July, as our chart below shows.
The collapse in inflation expectations is hardly surprising, given what's been going on in recent months and the related descent of interest rates. It would be a miracle if inflation expectations hadn't fallen sharply in the current climate.
From an investment perspective, one might wonder how to think of TIPS vs. conventional Treasuries these days. We can start by recognizing that most of the collapse in inflation expectations is due to the fall in yields on conventional Treasuries. TIPS yields have fallen too, but not nearly as much. The result, as our second chart below reveals, is that something close to parity now prevails for nominal and real (inflation-indexed) yields on Treasuries.
Normally, conventional Treasuries yield more than their inflation-indexed brethren. Why? The extra yield is compensation for exposing one's investment to the ravages of future inflation, if any. Conventional Treasuries only guarantee a nominal yield; TIPS only guarantee an inflation-adjusted yield.
Expecting some level of inflation is the normal state of affairs. Inflation, in the long run, usually dominates, thus the yield premium in conventional Treasuries. But these aren't normal times and so the yield premium for standard Treasuries has shrunk to almost nothing compared with TIPS. And rightly so, if we accept that deflation is the bigger risk at the moment.
In any case, real and nominal yields on 10-year Treasuries are roughly comparable. Buying either security means that you're locking in a yield for the next 10 years of slightly above 2%.
If you expect inflation to one day return, as your editor does, buying the 10-year TIPS is a no-brainer, since you currently don't have to accept a lower yield relative to conventional Treasuries and at the same time you receive an inflation hedge, effectively at no extra cost. Of course, buying an inflation-protected Treasury means locking in a real yield, which at just over 2% looks low relative to what's been available in past years, i.e., real yields as high as 3% to 4%. Nonetheless, a TIPS purchase also provides a varying nominal yield, and if/when inflation returns, nominal yields will rise.
But while running the printing presses at full steam implies that inflation will one day return, perhaps with a vengeance, we can't be absolutely sure about timing or even if higher inflation is fate. We believe it is, but, hey, the future's never fully clear. Meanwhile, some investors and traders are betting that deflation will run on for some time, perhaps longer than expected, and perhaps even for the next 10 years.
Pick your future—and your poison. We don't know which strategy will work out best, but we're supremely confident that one side of this coin will suffer badly. Alternatively, you could hedge the future with a passive allocation to Treasuries and buy an equal mix of nominal and inflation-indexed 10-year Treasuries.
If nothing else, at least we know this: investment choices are just as tough in times of crisis as they are when bull markets are everywhere.
Posted by jp at December 29, 2008 12:03 PM
There is a flip side to everything.
Banks can also slow the production of money, to charge people higher "real" rates. Infact in 2008, the Banks were the ones that told manufacturers to cut production!!
Posted by: Preserve at January 4, 2009 11:59 AM
Although much has been made of the surge in the monetary base and the Fed's balance sheet, few have bothered to look at the broad measures of the money supply: M-2 and MZM. Since 2000, a time when the GDP deflator has increased at about 2.6% a year, M-2 has grown at about 6% a year and MZM has grown at about 8.6% a year. M-2 was flat from 3/24 to 9/15. MZM was flat from 3/24 until 10/6. In fact MZM fell by about 1.5% between 8/15 until 10/6. Neither measure really regained traction until November despite the Fed pulling out all the stops. It's a lot harder to get the money supply to grow in a deflationary liquidity crisis than many people realize. The Fed had similar difficulties in the early 1930's (the monetary base was dramatically increased but M-2 declined) and Japan has had similar difficulties since 1994 (its monetary base has more than doubled). And even if the broad measures are growing again, velocity is almost certainly declining. In the final analysis the best indicator of future inflation is expectations. The market expects deflation. The only people who feel different seem to be Austrian School goldbugs and other cranks.
Posted by: Mark A. Sadowski at December 30, 2008 3:25 PM
It won't take 10 years to see inflation. It'll be here in the next few. Production is slowing and once inventories of cars, houses, etc. clear, we're going to have a ton of money chasing after a smaller supply of goods - the very definition of inflation. The way we're borrowing and printing money, hyper-inflation is inevitable.
Posted by: goldhawk at December 30, 2008 1:57 PM
Guess I'll go with the deflation decade approach. Yet hyperinflation should be recognizable if it occurs, and if one isn't a believer in anything in particular it won't be hard to change allocation. Actually think that expecting inflation is a little optimistic.
Posted by: dunnage at December 29, 2008 11:41 PM