Great piece from Fidelity considering the implications of the inflationary boom that seems to be driving stocks skyward (“Is this bull unstoppable? The key is how—and when—the Fed exits its historic stimulus program.”)
I highly recommend reading the article as it contains excellent charts showing the relationships amongst monetary policy, earnings, stock prices, and commodity prices.
Here are some key quotes:
“I believe it is becoming increasingly clear that stocks are following the playbook of an inflationary boom. The Institute for Supply Management’s (ISM) January 2011 manufacturing survey is the highest in years, earnings are strong, and now money supply growth is picking up steam. Ultimately, I fear this inflationary boom scenario may be followed by an inflationary bust (or stagflation), but perhaps that day is farther away than I have been anticipating.”
“Food and energy prices have moved sharply higher in recent months and appear to be trending higher rather than mean-reverting. If this remains the case, I believe the Fed could misstep by focusing on core inflation rather than the perhaps more relevant headline inflation. After all, for most of the world, food and energy inflation are critical matters.”
“How long can this go on before the “rubber band snaps,” either by commodities plunging in a deflationary crash (like in 2008) or the Fed being forced (by the bond market) to tighten and thereby undermine the recovery? Or what if the Fed does nothing and the dollar falls further and sends inflationary expectations skyward?”
Prices of long-dated treasuries continue to fall, meaning yields are rising. Below is the chart for the iShares Barclays 20-year Treasury Bond Fund (ticker: TLT).
The interest rate on the 30-year treasury bond is now 4.25 percent, up from 3.52 percent on August 31, 2010. (Disclosure: the author is currently long TLT.)
As my colleague Duru pointed out to me the other day, the long bond is looking a little sickly lately. Indeed, the iShares Barclays 20+Year Treasury Bond Fund (ticker: TLT) is down nearly 10 percent since its late August 2010 highs:
The bond market is not betting on deflation–at least not in the long run.
(adapted from the original post at at One-Twenty Two – added intro summarizing earlier Inflation Watch posts on TIPS and inserted recent commentary from Nightly Business Report)
We have covered the ups and downs of TIPS in the past here at Inflation Watch. Throughout the fall of 2009 we pointed out that TIPS were signaling relatively high levels of inflation and were far out-performing Treasurys (see here for example). In late January, TIPS imputed an inflation expectation above 3% over the next 5-10 years. Finally, in March, we wondered whether TIPS were then sginaling lower inflation expectations.
Well, last week, the iShares Barclays TIPS Bond Fund (TIP) surged to a fresh 2-year closing high on the same day the Federal Reserve issued its latest monetary policy statement. (TIPS = Treasury Inflation-Protected Securities – I will refer to “TIPS” when discussing the actual bonds and use “TIP” to refer to the ETF that uses TIPS as its major underlying asset). I was quite baffled by the action. My operating assumption for TIP has always been that its price increases with inflation expectations. Yet, here we are with inflation expectations apparently low and going lower.
After an evening of pinging various friends who were just as stumped as I was, I decided to sell all my holdings in TIP the next day. This was a hard decision as I had just finished responding to the warnings of a friend that TIPS now carry negative yield by telling him that this was the one part of my portfolio I am holding over the long-term. Almost a year ago, I even proudly declared I doubled my holding in TIP. However, I could not get over the feeling that it is not a good idea to hold onto an investment whose behavior makes no sense to you, not to mention the profits I had accumulated on my holdings far exceeded expectations.
After I sold, I (belatedly) decided to do more legwork and research what others are saying about TIPS. I discovered that my previous understanding of TIPS was far too simplistic. I was also quite surprised to find that there are actually sharp differences of opinion and interpretation regarding the action in TIPS. I was thrown for a huge loop when I learned that TIPS are included in the Federal Reserve’s new Treasury-buying program. So, I effectively sold my TIPS (through TIP) into the Fed’s buying program as the spike on Wednesday no doubt was in anticipation of this program.
I start off this review with my most startling discovery (really, an overdue realization):
I bought my first half of TIP on November 4, 2008, in the middle of the last deflationary scare. I was attracted by the significantly discounted price that came with a reasonable yield. I was also in the middle of making bets against deflation, believing that the Fed would be able to print its way back to an inflationary environment. I was generally bearish on the stock market, but if you had asked me whether TIP would keep pace with the stock market almost two years later, I would have responded by saying I was not that bearish! Yet, that is exactly where we are. Since Nov 4, 2008, both TIP and the S&P 500 have gained about 13%. When we add in dividend payments, I believe TIP pulls out about another percentage point ahead. Adjust for risk, and suddenly, TIP wins hands down. The chart shows the relative performance between TIP and SPY. Since at least the beginning of the recession, TIP has actually far out-performed the S&P 500 (click for larger view):
Last December, the WSJ reported that investors plowed $2 billion in TIPS in November betting that inflation would soon ramp. $3.9 billion went into commodity funds. On the year, these funds gained $59 billion while stocks funds lost $52 billion. At this time, TIPS prices implied “…inflation is expected to be less than 1% in 2010,…1.5% per year over the next five years and roughly 2.1% over the next 10 years.” So far, so good to me. This seemed to be a good explanation for why TIP was rallying into year-end. I also expected this to be the LOW end of the range for inflation – meaning more upside potential for TIP.
Fast-forward to the day before the Fed announcement and news hit that Warren Buffet is reducing his holding of long-term bonds because of his higher inflation expectations. So, maybe there is more upside potential in TIP even as it sat at 52-week highs amidst other news that some big investors are making the opposite bet. Still, the difference between yields on 10-year Treasurys and TIPS sat at 1.77 percentage points, down from a high of 2.49 percentage points on Jan 11. This spread further dropped on Friday to 1.66 percentage points, the lowest since last October. Bloomberg reported this spread as a standard estimate for inflation expectations.
Clearly, the interest and support for TIPS appears quite strong to-date.
Now, here are the various interpretations and strategies for TIPS I have discovered so far that seem most useful and worthy of consideration:
Buy TIPS instead of long-term Treasurys (New York Times – Robert D. Arnott, chairman of the asset management firm Research Affiliates in Newport Beach, Calif.)
“…if inflation begins to become a threat two or three years down the road, having the inflationary hedge of a TIPS bond will protect an investor against rising prices — which is something that a regular Treasury bond won’t do. In the meantime, individual TIPS are still government bonds backed by the full faith and credit of Uncle Sam. And even if…deflation persists for years, investors who buy individual TIPS will at least have the security of being able to recoup the face value of their bond at maturity, while still earning a yield of around 1.2 percent a year…that’s 1.6 percentage points less than what regular Treasuries of equivalent maturities are paying. But…’What are the chances of inflation being less’ than that for a decade?”
“Negative TIPS Yields Provide Some Tips on the Economy” (by Maulik Mody on Benziga)
“…what does a negative TIPS yield imply? The first thing that would come to our minds is deflation. But what it means is exactly the opposite. During deflation, the principal of TIPS would reduce and it would effectively provide lower returns as compared to other securities. In that case, it is better to hold on to the cash rather than buy TIPS. This will cause TIPS prices to fall and its yield to rise. But right now, as Treasury rates are falling on concerns of a shaky recovery, the TIPS yields are falling since inflation expectation remains constant. Because if Treasury yields fell and TIPS yields remain the same, the spread would narrow too much, indicating a bigger problem that’s already on peoples‘ minds right now, viz. deflation.”
Mody goes on to suggest that investors are still buying TIPS despite the negative yield because investors are trying to minimize losses in an environment in which economic growth is likely coming to a standstill WITH positive inflation.
“5-Year TIPs yields hit bottom” (from Kurt Brouwer’s Fundmastery Blog)
Brouwer started out interpreting the low TIPS yield as a bet on deflation, but corrected himself after reader response:
From a reader: “…The breakeven yield on 5yr TIPS is ~1.5%, on the 10yr TIPS it’s ~1.75%. People are willing to accept a 0% real yield in exchange for protection against inflation greater than 1.5% over the next 5 years.”
His further musings: “I wonder if it is a two-part decision. First part is to invest in Treasury securities for ‘return of capital’ even though that means there is no after-inflation yield. The second part is to hedge against higher future inflation. Frankly, it does not seem like a good bet to me when one can get decent yields on high quality intermediate government agency bonds and bond funds, but so be it.”
“Thoughts on TIPS and gold as inflation hedges” (by Calafia Beach Pundit)
“TIPS are going to deliver exciting returns ONLY if inflation turns out to be significantly higher than the market expects, and they could deliver disappointing returns if inflation doesn’t change much, if real yields rise because TIPS fall out of favor, and/or the economy picks up and Treasury yields in general rise. So TIPS are now a pure bet on inflation. Inflation has to pick up meaningfully for an investment in TIPS to do better than Treasury bonds. If it doesn’t, you’re going to either make a pittance or you’re going to lose some money.”
“Chart of the day: TIPS yields” (by Felix Salmon)
“…my feeling is that this is the ‘there’s nothing else to buy’ trade: a desperate lunge for safety in a world where everything else — including stocks and property — looks decidedly risky. Although with yields this low, even these long-dated TIPS stand to drop quite a lot in value if they revert to their mean yields.”
Readers posted a LOT of great comments in response to this article. I highly recommend the interested reader check them out. I cannot do them justice here.
“If the TIPS yield hadn’t fallen in unison with standard bonds, then it would mean that markets were now expecting far less inflation than before, since the TIPS spread we show above would have collapsed. This would be a truly ominous situation for anyone who believes deflation is a problem.
So while the negative/near-zero TIPS yield is startling, the alternative, ie. a higher yield, would be far more shocking since, if it were significantly higher right now, it would imply that markets had lost confidence in the Fed’s ability to fight off deflation. Hope this doesn’t happen, the verdict is still out.”
“Deflation and Negative TIPS Yields” (by Felix Salmon)
Salmon now slightly corrects the previous piece by stating:
“…deflation does provide one technical reason why negative TIPS yields aren’t necessarily as weird as they look. If we do have a brief bout of deflation, then TIPS coupons will be zero — which is actually positive in real terms. TIPS investors never need to give money back to Treasury. So it’s not necessarily true that you’re getting a negative real coupon: if there’s negative consumer price inflation for any length of time over the next five years, the zero bound on coupon payments might even things out. There’s also a lower bound of 100 on principal repayments, which may or may not come into play depending on the price/yield at which you buy your bonds.
So really, negative TIPS yields can be taken as a sign that the markets are beginning to price in some brief dip into negative-inflation territory. They’re not a sign that the markets are expecting no deflation.”
Whew! My head was spinning so much after reading articles like these, I had to go back and re-read several of them. And as if all those references were not enough, Nightly Business Report did its own brief segment today (August 16, 2010) on the historic yields on TIPS that was its own mini-head spinner. In the end, we learn that buying TIPS here can still make sense if you are worried about future inflation OR deflation.
Nightly Business Report (August 16, 2010: video or transcript)
Susie Gharib begins by announcing: “…something very unusual is happening in the market for Treasury Inflation Protected Securities or as they’re called TIPS. The five year TIP is yielding zero. That’s happened only once before and it means investors holding these Treasuries are actually losing money to inflation.” Erika Miller repeats the point: “…the yield on five-year TIPS is hovering near zero. That means that once inflation is factored in, the bonds are actually losing money.” But the very nature of TIPS are supposed to provide a protection against inflation, right? Fortunately, two experts are interviewed to clear up the fog.
Jerry Webman, the chief economist at Oppenheimer Funds, states that by buying TIPS now “…You are taking an opinion here that it’s worth giving up current income now for the possibility that inflation will cause the principal value to appreciate over time. But then an economist at BNP Paribas, Julia Coronado, points out that TIPS can provide protection here against BOTH inflation AND deflation:
“TIPS have a floor at zero, so you don’t actually lose principal if we actually have deflation or inflation becomes negative. So, it does provide you some insurance against the downside and really insures the real value of your principal….If you did have the view that deflation is a very likely outcome, then the yields we are seeing could make a lot of sense. So, if you actually fear that one of the more extreme scenarios is likely, either in inflation or deflation, other assets are not likely to perform very well.”
In the end, I have come to terms with my trade and TIP-less portfolio. The upside potential from here seems pretty small compared to the downside risks. Moreover, I had never given much thought to TIP’s dependency and relationship to regular Treasurys. To the extent the price appreciation in TIP has come from plummeting Treasury yields, I am much less interested in it. I am still far from the deflation camp, and I will wait and see how the current deflation panic plays out before deciding what to do next, if anything, with TIP.
I also now interpret the Fed’s purchase of TIPS alongside Treasurys as an attempt to maintain a spread between the two so that imputed inflation remains positive. The Federal Reserve may now distort the signal on inflation expectations that should be embedded in TIPS. One more reason for me me to avoid TIPS for now.
For one last check, I decided to review the prospectus for TIP. (Note well, I almost NEVER read the prospectus on anything!). This provided some final clarity for me.
From the prospectus:
The Fund’s income may decline due to a decline in inflation (deflation). If there is deflation, the principal value of an inflation-linked security will be adjusted downward, and consequently the interest payments (calculated with respect to a smaller principal amount) will be reduced. If inflation is lower than expected during the period the Fund holds an inflation-linked security, the Fund may earn less on the security than on a conventional bond.
Interest rate risk:
As interest rates rise, the value of fixed-income securities held by the Fund are likely to decrease. Securities with longer durations tend to be more sensitive to interest rate changes, usually making them more volatile than securities with shorter durations. To the extent the Fund invests a substantial portion of its assets in fixed-income securities with longer maturities, rising interest rates may cause the value of the Fund’s investments to decline significantly.
Prices of bonds, even inflation-protected bonds, may fall because of a rise in interest rates. However, because most of the bonds in the Fund’s portfolio are inflation-protected obligations of the U.S. Treasury that are adjusted for inflation, the Fund may be less affected by increases in interest rates and interest rate risk than conventional bond funds with a similar average maturity.
…It is possible that prices throughout the economy may decline over time, resulting in ‘deflation.’ If this occurs, the principal and income of inflation-protected bonds held by the Fund would likely decline in price, which could result in losses for the Fund.
For each full quarter of 2009 through March 31, 2010, TIP traded 85% of the time within +/-0.5% of its true NAV. (This reassured me that the performance of TIP is not the result of some out-sized premium to net asset value).
Full disclosure: long SSO puts
From the Wall Street Journal:
A closely watched gauge of inflation expectations is telling the Federal Reserve that it can leave rates low for a while to help the economy heal.
The five-year, five-year forward breakeven rate–that is, the market’s expectations for inflation between 2015-2020–has come down sharply since February and currently implies an inflation rate of 2.60% for that period. That’s down 0.30 percentage point from the historic high of 2.91 percentage points on Feb. 1, which implied an inflation rate of 2.91%.
After rallying strongly in late 2009, the iShares Barclays TIP Bond Fund is down about 2 percent so far in 2010:
But inflation-unadjusted Treasury long bonds have fared only slightly better. The iShares Barclays 20+ Year Treasury Bond Fund, for example, is just about flat year-to-date:
Perhaps inflationary expectations have declined slightly during the past two months, but if so not by much.
(Disclosure: The author recently purchased an inflation-adjusted bond fund.)
Reader Jay writes:
Do you think TIPS are a good inflation hedge? Some say the Fed will raise interest rates well before significant inflation is captured in the official CPI. Theoretically does the market go up during inflation? What are some other good hedges other than gold and gold stocks?
Hm, Inflation Watch isn’t an investment blog. I’d like to take a stab at Jay’s questions, but please keep in mind that nothing on this blog should be construed of as investment advice. (Do your own research!)
1. Treasury inflation-protected securities (TIPS) were a steal in late 2008, when everyone was worried about deflation. Less so now, because the market has priced in higher inflation expectations. Nonetheless, in my opinion, TIPS are an excellent inflation hedge if held over a long period of time. I don’t personally own TIPS but I would seriously consider buying the iShares Barclays TIPS Bond Fund as a long-term holding if prices pull back significantly from current levels.
2. The short answer is that the stock market can go either up or down in times of inflation. Certainly there are many companies (for example, those that have pricing power) that can prosper in times of inflation. But for the market as a whole, generally stable prices are best. So a complete answer to Jay’s question is that it depends on a number of factors, including how much inflation there is, how the Fed responds to it, and how predictable the inflation rate is. For example, low, predictable inflation that is carefully kept in check by the Fed is a lot better for the stock market than high, unpredictable inflation that is ignored by the Fed.
3. Other good inflation hedges, aside from gold and TIPS, include real estate (or real estate investment trusts), land, commodities, and any asset denominated in a foreign currency.
At times during the past 18 months, I have owned the ProShares UltraShort 20+ Year Treasury Bond Fund (TBT). I have also owned long-term puts on the iShares Lehman 20+ Year Treasury Bond Fund (TLT). Although both of these holdings performed extremely well, I do not recommend them now and I certainly do not recommend them for long-term investors.
Do you have a question for Inflation Watch? Send us an e-mail at inflationwatchblog -at- gmail -dot- com.
Inflation-protected treasury bonds continue to outperform standard (non-inflation-adjusted) long-dated treasuries. Click on the chart to expand it:
This is a sign of rising inflation expectations.
Update: Given the above, this comes as no surprise.