Questions about TIPS

From Angus:

The 10 treasury bond is yielding around 1.7% (none of what follows relies on the exact values of the numbers).

The 10 year TIPS yield is around  -.7%.  So a common calculation of inflation expectations, so called break-even inflation is at 2.4%.

From this information, I arrive at two important (at least to me) questions:

(1) Is this a reasonable measure of inflation expectations and (2) If so, what does it mean about the economy?

I question (1) because of concerns about the lack of liquidity in the TIPS market, the old issues of market segmentation, and just generally because equilibrium conditions in financial markets that aren’t enforced by pure arbitrage don’t actually seem to hold in the data.

I did a bit of research and found a couple Fed branch bank papers on the topic (see here and here).  Both papers conclude (if I am reading them correctly) that the break-even inflation calculation of inflation expectations probably understates expected inflation!

So that leads to question 2. If Inflation expectations are above 2.4%, but the 10 year treasury is yielding 1.7%, why are people holding 10 year treasuries? Because the equilibrium real interest rate on safe securities is negative, like around -1.0%? 4 years after the crisis, risk aversion is so high that people are willing to accept a negative return for in exchange for safety? So either the supply of safe assets is very small, or the demand for safe assets is overwhelmingly high?

If inflation expectations at the 10 year window are rising, but returns on 10 year treasuries are simultaneously falling, then the equilibrium real rate of interest on safe assets is getting lower and lower (in our case more and more negative).

Does this mean that 4 years after the crisis, people’s willingness to undertake risky investments is actually falling? If so, isn’t that a very bad sign for the direction of future economic activity?  The Baa seasoned bond yield is 4.9%. If inflation expectations are 3%, then the real return to capital is 1.9%?

Or does it mean somehow that the supply of safe assets is shrinking faster than the demand for safe assets is falling? Can we just blame Europe?

Or are we just making a big mistake in calculating inflation expectations?

Comments

I vote for:

"4 years after the crisis, risk aversion is so high that people are willing to accept a negative return for in exchange for safety."

Overlay the last twelve years in financial markets against baby boomer demographics (currently age 52-66), and I expect very low real interest rates to persist for quite some time.

Who owns TIPS and are they the kind of people who do TIPS/Treasury swaps?

(I have some TIPS in my asset allocation because I have TIPS in my asset allocation. I suspect I am not alone.)

The Fed is buying TIPS so the rate isn't meaningful.

The Fed is apparently buying everything.

http://www.zerohedge.com/news/2012-09-22/fed-now-owns-27-all-duration-rising-over-10-year

According to David Beckworth, it's mostly foreigners & private individuals, not the Fed. Quantities matter.

I think the first paper is saying that true inflation expectations of the bond market, adjusted for liquidity premium are lower than survey based data.

People are holding TIPS as a hedge. To quote the paper, as protection against the risk that inflation will overshoot its expected path

Since TIPS have negative real yields for maturities of between 0 and 20 years, it seems like most retail investors would come out far ahead by instead buying inflation-indexed savings bonds (up to $10k a year), which have 0% real yields for any maturity (after one year) and many more tax advantages to boot. 0% real yield is obviously better than a negative real yield.

As far as why people are holding 1.7% nominal treasury? as a hedge against the risk that inflation will significantly undershoot its expected path

Imagine you have exactly a 10 year liability. In 10 years, you'll need to make a payment. What can you possibly hold to immunize the liability ? a mix of 10yr TIPS and nominals. Anything else doesn't guarantee that you'll have the principal.

Since the Federal Reserve is massively buying US obligations, doesn't this distort the market in ways that interfere with analyzing what a rational investor might do?

Uncle Ben is telling you not to save dollars, but to spend them. Just as when interest rates rise, he is telling you not to spend, but to save.

And, he is telling the Chinese: you want to purchase dollars to support your currency, go right ahead, we have plenty more.

I don't think this is Ben's main motivation, but it certainly helps.

"he is telling the Chinese: you want to purchase dollars to support your currency, go right ahead, we have plenty more." ..and the petro states, too.

This reminds me of an old Emo Phillips joke from the 80s.

"""I don't worry about the deficit. When the Japanese ask for their money back, we'll just say we don't have it. When they ask, 'what did you do with all that money we gave you'?' We'll say, ' we spent it on all those nuclear bombs over there.' and then the Japanese will say, "Okay, you can keep the money a little longer."""

The Chinese have a simple way to not give the FEDs trillion of dollars: make their currency convertible, and let domestic wages rise. Of course, such a policy would move economic power away from Party hands, so it's not so surprising Chinese Communist Party (collectively) would rather be beholden to Tim Geitner than their own middle class.

They've been relaxing controls on currency for the last few years. Given what happend to Russia, it would be nuts to do let it float all at once.

TIPS returns the past three years:
2011 13.56%
2010 6.31%
2009 11.41%

I found a Treasury report that says TIPS were only 11% of the Treasury market in 2008. Maybe if there were more TIPS, or maybe when the Treasury starts issuing floating rate bonds next year, the Treasury rates would rise.

TIPS have underneath the inflation adjustment a good old fashioned long term Treasury bond. When rates fall as they've done the last few years (really the last 30), TIPS rise on that basis. Nothing to do with inflation per se.

If and when inflation comes back and long term Treasury rates go up again, folks will be pretty surprised watching their TIPS drop in maket value

In my opinion, people (foolishly or not) look at the last three years' returns and buy TIPS as an asset with appreciation potential. Forget inflation expectations, they have a return expectation higher than the yield. When is it ever reasonable for a return expectation to be higher than the yield? When you expect rates to fall. When do you expect rates to fall? Not just when you're afraid. Not necessarily in an environment that's so terribly risky, so much as one where you expect further monetary accommodation. That's been a good trade for the past 3 years. Investors are making a frightening risk-reward tradeoff, perhaps, but they see "upside" to a 1.7% 10-year...why shouldn't it go to 1% if the Fed is going to continue to keep rates low for an 'extended period'? Implicitly the market is betting it will be a while before we see a normal business cycle again.

4 years after the crisis, risk aversion is so high that people are willing to accept a negative return for in exchange for safety.

It's consistent with the huge amount of money that's sitting on the sidelines at a time when corporate profitability is seemingly not that bad.

At some point, even bad news would be good news, wouldn't it? Something would be going terribly wrong, but at least you'd know which thing, and be able to plan for it.

It makes you wonder if it might have been better to do a minimal stimulus and focus instead on keeping deficits low and minimizing uncertainty. Stimulus isn't so stimulating if it touches off a capital strike.

'Minimizing uncertainty': how do you do that exactly?

Can you point to a time when there wasn't 'uncertainty' about the future? That's about the most constant thing in the universe after the speed of light.

While no one knows the future, there is an awful lot of policy uncertainty in the U.S., EU, and China right now. By some statistical measures, it is near the highest it has been.

Just to start, the US doesn't even know what its tax rates will be next year! There are enormous regulatory burdens not yet published for review under Obamacare and Dodd-Frank (tens of thousands of pages for each), and the entire health care industry and financial industry are basically left unsure as to what investments they can even make in the medium term, or if some of their existing investments will be less or even unprofitable under the new rules. The US election this year could have substantial policy effects, much more than the usual shift in the status quo we have historically been accustomed to. And the Fed is far away from the rate path it previously followed (which roughly corresponded with the Taylor Rule) because of zero-bounded rates, so the growth of the money supply is itself unpredictable over the medium term.

I hope I don't have to set forth all the uncertainty in the EU. Suffice it to say that it is unclear if the Euro will be the currency for all of the EU's current members, and if other countries besides Greece will have to default on at least part of their debt in the medium term.

China is undergoing a once-a-decade leadership transition that seems to have coincided with a possible popping of their infrastructure/investment bubble.

Taken together, this is seemingly a time of particularly heightened uncertainty for economic players all around the globe.

I will admit there are some contra-indicators, such as the low level of VIX for US equities. But that may be more an example of QE3 putting a floor on the market than real sentiment that uncertainty is low for investors.

I actually agree 'uncertainty' is pretty high right now everywhere. But I'm honestly wondering when it wasn't. Even times of lesser uncertainty were pretty uncertain. Post 9/11? Clinton era budget battling (which we are echoing now)? Gulf War I?

To be able to make decisions in the face of uncertainty is pretty much the human condition, always.

I would suggest that there is certainty in one respect; debt levels of government, corporations and individuals have risen to such a level as it is inevitable that a good portion will be written off. That means that someone somewhere will lose money. The rational response is to hunker down and set yourself up to survive. The only uncertainty is how much of this debt can the various central banks buy, or rather how close to the edge of the cliff can the monetary authorities place themselves.

I don't know about you, but the Fed announcing that they will buy $45 billion of MBS monthly to perpetuity didn't fill my heart with visions of unbounded prosperity, but rather a dark thought of what happened last time the housing market was pumped up.

"Can you point to a time when there wasn’t ‘uncertainty’ about the future? "

No, I can only point to times where we thought we knew more than we did.

Let's not forget the embedded optionality of TIPs, thus boosting its price and lowering its yield. Not sure to what degree this affects the numbers, though.

As an owner of (older) TIPS bonds (and man, even the IRS still isn't quite sure how to tax them), I think some people just might be losing sight of how they are inflation protected - a lump sum is added to the principal.

Which looks something like this -
1. Bond pays .5% interest, Inflation at 1% first year, 1% of par value is added to the bond.
2. Five years later, bond is still paying .5% on all previous adjustments, inflation is at 5%, 5% of the total value is added, including all the previous adjustments, if the statement from the Treasury and my calculator skills are to be trusted.
3. Five years later, bond is still paying .5%, inflation is at 3%, and the total amount of the bond reflects all inflation which the bond is 'protected' from. In other words, one could say that the inflation adjustment is also inflation adjusted - how very generous of the Treasury, I might add. (The Germans almost have a word for it - Zinszins, which covers the idea of iteration, if not the precise mechanism.)

Though technically, if deflation were to occur, my 30 year bonds 'adjustment' would have their amount reduced to reflect that. Thankfully, we have a Fed chairman whose entire published history suggests he will do everything possible to ensure that my TIPS continue to make a nice return on my investment.

'because of concerns about the lack of liquidity in the TIPS market'
Um, trust me, the 30 year TIPS paying 4% interest currently are highly, highly liquid, though they are not exactly being offered for sale in large amounts. (And this does not include the personal aspect of certain formalities involving living outside of the U.S., which make them highly, highly illiquid unless I make an appointment in Frankfurt first) (The Treasury has also offered to buy them back, for that matter - without reflecting future principal adjustments, that is.)

'why are people holding 10 year treasuries?'
A. Beats me
B. Because most people aren't holding treasuries, and in essence the entire bond market has become something of a shell game? Neither the Treasury nor the Fed actually care about anything but the bookkeeping when moving the bytes around.

'Can we just blame Europe?'
Why not? Sadly, the Bundesrepublik refused to follow the extremely generous American TIPS model when creating their own inflation protected bonds, making the bonds quite unattractive from my perspective.

Actually, Glassman was a fool in his DOW 36,000 prediction, but he definitely nailed just how attractive TIPS were when introduced in the mid 1990s. (Only investment advice I ever followed from him, though he was always amusing to read in the IHT.) They have handily outperformed the stock market, particularly in an environment which is not exactly inflationary. And yes, you can use the Treasury to essentially handle everything for free as long as you stay under 100,000 dollars, which is not really the sort of numbers this post is discussing, but is definitely an amount which most posters here can encompass.

Maybe the real question is why most people sat on their hands in terms of TIPS - and that minus yield is not quite accurate in regards to TIPS (at least of the older style) - the accounting of TIPS remains a fascinating discussion - and ties directly into the tax discussion.

Inflation expectations are between 2 and 3%. Why is the price of safe assets so high? Part of it is supply constriction: European bonds are unsafe. But more of it is low expected future demand. In a low-growth, high-unemployment environment, risk:return increases, pushing up demand for safer assets relative to riskier assets. So: low inflation expectations should (in this environment) correlate to high demand for safe assets.

If Inflation expectations are above 2.4%, but the 10 year treasury is yielding 1.7%, why are people holding 10 year treasuries? Because the equilibrium real interest rate on safe securities is negative, like around -1.0%? 4 years after the crisis, risk aversion is so high that people are willing to accept a negative return for in exchange for safety? So either the supply of safe assets is very small, or the demand for safe assets is overwhelmingly high?

I think the reason for this is that Treasury securities have increasing evolved into an intermediary asset, not simply an asset one "holds" in order to achieve "safety" but one uses in ways not unlike currency to facilitate larger-scale exchanges accross national or institutional lines, or as highly-liquid "checking accounts" for vast sums. My theory - if the FDIC raised its insurance limit for deposits to infinity, the price of Treasury securities would decline, because people would simply hold the cash. Instead, paying a slightly negative real interest rate over the life of a long-lived asset is kind of like paying a fee for having large amounts of cash in assets with roughly the same safety and liquidity as FDIC-insured accounts.

This is definitely a factor, +1

FWIW, the Cleveland Fed, that wrote the second working paper he links, has another method that estimates 10 year inflation expectations as lower, 1.32 percent.

Thus, I'm not sure that he's reading the second paper correctly, since the 1.32% per annum estimate for 10-year expected inflation is obtained by implementing the method in the working paper itself.

How does anyone really know what the future inflation rate will be? The prices of these instruments are the ones that clear the market. They are similar to the lines on NFL games. Generally, people expect that what is now, will continue. They are always surprised when things change - see Financial Crisis of 2007.

That being said, these prices are all we have right now and provide a guide to investors in weighing alternatives (thank you F.A. Hayek).

Not just safety, but convenience, liquidity, and option value as well. Stockpiling beans may offer a better return but we are satiated with beans for their anticipated span after which their return falls even faster. We so much want future goods, we are willing to abstain from current ones and pay more for them then.

Yes, Angus, on all counts. Everything you are saying is the talk of fixed income analysts and traders right now. There are other implied measures if inflation andthe TIPS spread has all the flaws you cited - textbook answer, really. But none of the other measures or predictors of inflation seem to be doing any better.

It's all a crap shoot right now. Government has severely distorted all price and expectation signals.

The real return on T-bills is probably around -2.5%. If you think T-bill rates will be held down for a long time, then you can go long the 10-year and short T-bills (or 2-year notes) and capture the difference in rates. This is actually what the Fed is doing so you are not "fighting the Fed". Of course, once the Fed stops doing this trade, you must get out at all costs.

When I sold my business in early 2008, I put about half of the proceeds into TIPs. Almost everyone whose advise I rely on hated the idea. The truth is I was thinking of it more as an insurance policy than an investment. It has turned out to be a surprisingly good investment so far.

When people watch their stocks lose 50% they start to think of zero as a better return than they used to.

If you sold your business in 2008, depending on what month you were investing, equity could have been a very lucrative decision. Ex post, I don't think a pure TIPS allocation was anywhere near optimal. Ex ante, inflation fears were overblown as was equity volatility. A diverse portfolio would have and remains your best allocation regardless of your risk aversion. That said, I see no safe havens for worst case scenarios, least of all TIPS.

As Angus implied, risk taking is below optimal in this ideal environment for starting a small business or investing in commercial real estate, VC, or other alternatives.

I agree with most of that Willits. I was trying to shed some light on investor psychology, not offer investment advise.

I did hold onto the equities I owned and add some to that back then. Of course, now I wish I had added more. I agree a diverse portfolio is the best protection and see this as part of that. TIPS was never more than 20% of my total assets. I am interested to hear why you think TIPS are the worst safe haven.

The 'tips' price has been the same in the dollar terms for years. But it has dropped in gold three times in the past 5 years. Want to see what is the gold price at the moment? Please check my website: http://www.sh1ny.com

Max Goldberg

"So either the supply of safe assets is very small, or the demand for safe assets is overwhelmingly high?"

Put me down for this theory. A whole lot of sovereign debt which would normally have been have has gone, simply via guilt by association and contagion effects associated with bailout proposals from being totally safe to less than totally safe. Mortgage backed securities with additional credit default swaps used to be considered virtually as safe as Treasuries, but this assumption is no more. Municipal budgets are tight and somebody somewhere is bound to file a Chapter 9 municipal bankruptcy for $$$$ sooner or later. The financial crisis ad hoc guarantee of privately insured money market funds that had broken the buck called attention to the fact that history might not repeat itself, making money market funds seems less like a virtually as safe as Treasuries investment. Metals seem overvalued.

In the past few years, the supply have safe investments has plunged, while the ranks of people who are shell shocked after the financial crisis and thus have less risk tolerance, or who are simply getting close to retirement age and hence would have a less risk tolerant asset allocation has surged. Supply down, demand up, price falls, textbook Microeconomics 101. Since TIPS are a pretty small number relative to all outstanding securities, and has a probably disproportionately large number of "dumb money" investors, it doesn't take much for a little skew to arise.

Moreover, since confidence in whole asset classes, rather than particular bond issuances, has fallen, making more safe assets to meet demand is no small task.

One other possibility is that after the U.S. flirted with not extending the debt limit and had its bond rating cut, that Treasuries and TIPS no longer represent a risk free rate of return. One way to interpret a negative rate of return for TIPS, which are inflation risk free, is that the risk of default loss (after adjusting for inflation) has a mean market value of 0.7% (one might also call this "political risk" associated with U.S. sovereign debt) and that inflation expectations are 2.4% (this is after all, an apples to apples comparison).

+1.

It's all very weird and unprecedented though. To take a simple example: when the US got it's credit rating cut, everyone went immediately "risk off", and Treasuries rallied like mad.

We are through the looking-glass- should be fun.

On your last paragraph though...

It seems to me both Treasuries and TIPs reflect default risk, so the yield difference here is purely expected inflation I think. Anyone who knows inflation will be outside the range of 2.2%-2.5% over the next five to thirty years would presumably be arbitraging like crazy right now.

In general, default risk should increase the nominal yield on both Treasuries and TIPs - this is why corporates carry a higher yield than Treasuries - so I don't see it as part of the explanation for TIPs yields, but I might be missing your point.

There are explicit credit default swaps you can buy on Uncle Sam, aren't there?

One indirect way to see Sammy's default risk, is to compare the yield on, say, the 30-year Treasury (2.91%) with a 30-year swap (2.70%).

Swaps carry "counterparty" risk, but contracts can be structured with "mark-to-market" true-ups, which, judging by the market, have been considered less risky than US government debt since the onset of the financial crisis.

"Does this mean that 4 years after the crisis, people’s willingness to undertake risky investments is actually falling?"

Not necessarilly. The Yield on junk bonds is at an all time low, too. And, the stock market keeps rising. This says to me that money is flowing into both risky and safe financial assets in a big way.

That money isn't flowing into real investment, though, is a troubling.

Brian I am totally agree with your thoughts.

Comments for this post are closed