During October's broad market sell-off, investors jettisoned Treasury Inflation-Protected Securities (TIPS) right along with everyone else. Now, yields on TIPS are sitting at historical highs, especially for the shorter maturities. More recently, the business media has taken note of just how cheap TIPS are and most are suggesting that they are now a great bargain. I too think certain TIPS represent decent value for those looking for a safe haven, but I am more cautious about the longer-term prospects for these securities.
Average Weekly Yield on 5-year TIPS:
2003-2008
Source: U.S. Federal Reserve
The chart above shows, although it is admittedly difficult to see, that the average weekly yield on 5-year TIPS has soared over the past couple of months. At the end of August (8/29), the 5-year TIPS yield was 1.16%. By the end of September (9/26), it had risen 64 basis points to 1.80%. In October, it surged 193 basis points, ending the month at 3.73%.
The Oct. 31 average weekly yield is the highest on record for the 5-year TIPS. (Available Federal Reserve data goes back to January 2003.) That yield is also 100 basis points higher than the previous record of 2.73% on June 15, 2007.
Average Weekly Yield on 10year TIPS:
2003-2008
Source: U.S. Federal Reserve
The same trend of rising yields is evident with the 10-year TIPS, but to a lesser degree. At the end of October, the 10-year TIPS yield was 3.07%, up 105 basis points for the month and above the previous peak, also recorded on June 15, 2007, of 2.76%.
At current levels, TIPS spreads (i.e. the difference between the TIPS yield and the yield on the comparable maturity Treasury note) are at record lows. The 5-year TIPS spread is actually negative. With the average weekly yield on the 5-year constant maturity Treasury at 2.77%, the 5-year TIPS yield of 3.73% translates into a spread of -97 basis points. The 10-year TIPS spread, calculated in the same manner, was 85 basis points, which is historically quite low.
There are a few possible explanations for these very low spreads. First, some people suggest that TIPS have been subject to the same forced selling as stocks and non-U.S. Treasury bonds. The theory is that hedge funds that carried TIPS in their investment portfolios were forced to liquidate due to redemption requests and lender demands that they reduce leverage.
To me, this is not a satisfactory explanation. I imagine that hedge funds and other institutions forced into liquidations owned straight U.S. Treasurys as well and we have not seen the same back-up in yields in that market. True, the straight Treasury market is much more broad and deep than the TIPS market, so it could more easily handle the increase in supply, but if investors generally perceived TIPS to be a safe-haven and a good deal, sufficient buyers would have emerged, forestalling the back-up in yields. Furthermore, the rise in TIPS yields continued (and accelerated) in the final week of October, a week that saw the stock market's best gains since the 1970s. Did the forced liquidators offload TIPS and buy stocks at the same time?
Second, with the decline in commodity prices, and oil in particular, inflation is likely to give way to deflation for at least the next few quarters. A general decline in prices, as reflected in the CPI, would cause the semi-annual inflation adjustment to be negative. So the theory here is that investors in TIPS are demanding higher current yields to compensate them for the risk of a negative inflation adjustment.
This, I believe, is a more likely, but probably still incomplete explanation. Lower commodity prices will likely cause a drop in the CPI in the months ahead, but many proponents of this argue (correctly, I believe) that deflation will not be with us for more than a year or two.
Most proponents of TIPS look at the so-called break-even yield, which is equivalent to the TIPS spread, to argue that TIPS are a great bargain today. For example, the 10-year TIPS spread of 85 basis points is an estimate of the projected rate of inflation over the next 10 years that is embedded in the 10-year Treasury note. Since inflation over that period is almost certain to be higher, they advocate that investors should buy TIPS.
However, I think that it is more appropriate to look at the TIPS yield and ask why is it so high? In the past, high TIPS yields have mostly been seen in rising interest rate environments. A general increase in interest rates pushes TIPS yields higher perhaps because investors worry that the inflation-adjustment in TIPS will lag the general increase in interest rates.
In this case, I think that there may also be concerns about the use of the CPI to measure the inflation adjustment. The CPI is used calculate inflation adjustments not only on TIPS, but also in many other areas, most notably payments to recipients of Social Security. With the escalating cost of the bail-out plan and the prospects for a ballooning of the Federal government's budget deficit due to other efforts to combat the recession, there is growing pressure on the government to reduce its spending wherever possible.
The cut in commodity costs will help lower the CPI, but housing costs are the biggest part of the CPI and they are falling as well. The current methodology for calculating housing costs, called owners equivalent rent, was criticized during the housing boom in 2005 because it was felt that it was not capturing the true cost of house price appreciation. This suggests that the methodology will also not reflect the full brunt of the decline in house prices that has been evident over the past couple of years; but it is certainly possible that the government may look at changing the formula now in an effort to reduce its outlays.
Earlier this week, the TIPS market began to recover, probably in response to articles in Barron's and elsewhere that touted their value. It may very well be, then, that TIPS yields will recede in the days and weeks ahead.
If I am correct, however, in my assertion that the recent declines also reflect concerns about the CPI as a measure of inflation, then it is likely that TIPS yields will remain above their historical averages.
November 4, 2008
Stephen P. Percoco
Lark Research, Inc.
P.O. Box 1409
Mashpee, MA 02649
www.larkresearch.com
(732) 763-0763
incomebuilder@larkresearch.com
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