Well, TIPS were created for investors that wanted to protect themselves from price inflation. By creating an instrument that protected investors from price inflation, the US Treasury Department was attempting to create an instrument that yielded what can be called a “real” interest rate.
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Thus, one could argue that if an investor does not expect much price inflation in the future, then that investor has little or nothing to gain from investing in TIPS.
Right now the year-over-year rate of increase in the GDP price deflator for the third quarter of 2013 is 1.4 percent. This is down from the same measure for December 2010, 2011, and 2012 of 1.8 percent. Inflation does not seem to be a major issue in the US economy at this time.
It can be argued that if an investor does not expect much price inflation in the future, then the investor might even come out worse investing in TIPS than by investing in basic Treasury securities.
The reasoning here is that the real yield on risk-free debt issues should approximate the real rate of growth of the economy.
Historically, the yield on TIPS, if it assumed to be a “real” rate of interest has tended to lie below the rate of growth of the United States economy. Thus, the financial markets seem to be telling us that there are other factors impacting the yield on TIPS other than just the growth of the United States economy.
For example, the current, year-over-year rate of growth of real GDP in the United States economy is 1.8 percent. The current yield on the 10-year TIPS is around 0.67 percent.
In the current situation, I have argued in previous posts on LearnBonds that the major reason that the yield on the 10-years TIPS is so far below the expected growth rate of the economy is that the United States has been a safe haven for large amounts of money that left Europe because of Europe’s financial difficulties.
A couple of years ago, vast amounts of money fled the European financial markets as the economic situation in the eurozone seemed to be worsening. During this time period, the yield on the 10-year TIPS actually became negative and stayed that way for an extended period of time.
This year, as the financial situation in Europe improved, this risk-averse money began to flow back into Europe and the yield on the 10-year TIPS moved back into positive territory and up to the current yield now observed. This is just one instance of how the yield on TIPS can deviate from the expected real growth rate of the economy.
This is just one example of a reason why the yield on TIPS might lie below the expected real growth rate of the economy.
Historically, the TIPS yield does lie below the real growth rate of the United States economy. So, if there is little or no inflation in the economy, an investor would be better off to invest in regular notes and bonds rather than in TIPS.
I expect that the real growth rate of the economy over the next ten years or so will be somewhere around the 2.00 percent to 2.50 percent range. If so, the yield on the 10-year TIPS could rise up to the 1.75 to 2.25 percent range. This would imply further price erosion in the bond for any current commitment of funds.
Another question a potential investor might ask concerns the estimated rate of inflation that is built into current financial market prices.
Recently, the bond market’s view of anticipated inflation over the 10-year horizon has been relatively stable in the 2.1 to 2.2 percentrange. This is with, as mentioned above, the rate of inflation in around 1.4 percent. Deflation is not built into the current bond-pricing structure.
Note that this expected rate of inflation built into the 10-year maturity issue is down from what it was in March 2013. At that time the bond market was expecting inflation over the next ten years to run in the 2.55 percent to 2.65 percent range.
So inflationary expectations have dropped over the past nine months. And, deflation is not totally out of the minds of some bond investors, given that the producer price index, year-over-year, has fallen for the past three months. Some investors are even recalling the situation in Japan over the past ten years or so.
TIPS are not the security to invest in if inflation is expected to decline or even become deflation.
This gets us to our final point. There is a lot of uncertainty in the market place about where inflation is going to go. As just described, some investors see a falling rate of inflation with the possibility that prices might even start to decline in the future.
On the other hand, other investors see all the money that the Federal Reserve has pumped into the financial system and can’t believe that there will not be accelerating rates of inflation at some time in the future.
So, where do you bet? What’s your view on how fast the US economy will grow? What do you see happening in the world economy that will impact the flow of funds into the United States…or away from it? How fast do you feel that prices will inflate in the future…or deflate?
Or. maybe you just stay away from investing in TIPS because the uncertainty about the future is just too great.
It’s your call!
About John Mason
John has been the President and CEO of two publicly traded financial institutions and an Executive Vice President and CFO of a third. He has also spent time as an economist in the Federal Reserve System and worked for a cabinet secretary in Washington, D. C. In addition John taught in the Finance Department at the Wharton School of the University of Pennsylvania for ten years. He now currently has a column on the blog Seeking Alpha and is ranked number 3 in terms of readers on the economy. From this column, two books have been published this past year from earlier blog posts. John is active in the shadow banking world, the venture capital space, and in angel investing. Other than that John works with start ups and early stage organizations, for profit and not-for-profit.
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