Chart of the day: TIPS yields

By Felix Salmon
August 11, 2010
Paul Krugman notes today that 5-year TIPS are trading with a negative real yield, which prompted me -- with the help of the great Frank Tantillo -- to navigate the Fed's data download program to generate this. (Bigger version here.)

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Paul Krugman notes today that 5-year TIPS are trading with a negative real yield, which prompted me — with the help of the great Frank Tantillo — to navigate the Fed’s data download program to generate this. (Bigger version here.)

tips.png

Both 5-year and 10-year TIPS yields are trading at or near their all-time lows right now (the chart only goes up to the close of business yesterday, and yields have fallen again today).

I’m a bit stumped, however, on what exactly this means. The last time that TIPS yields dropped below zero, the cited reason was “investor speculation that inflation will quicken as the U.S. economy slows”. But that doesn’t seem to be the case right now, with the 5-year Treasury at 1.44% and the 10-year at 2.71%.

So what’s going on? Scott Grannis has his own ideas, which don’t bode well for the medium-term future of the economy as a whole:

You can think of real yields on 5-yr TIPS as a good proxy for the market’s expectation for real GDP growth, mainly because there should be some reasonable connection between the risk-free real yield an investor can earn on TIPS over the next 5 years and the real yield on cash flows tied to the economy’s performance via generic equity exposure. For example, if expectations for economic growth were healthy (e.g., 4-5% real GDP for the next several years), then an investor would be foolish to put his money in 5-yr TIPS that promised a zero real return. Cheerfully buying 5-yr TIPS with a guaranteed real yield of zero only makes sense if one has very grave doubts about whether the economy can generate any real growth at all in the coming years.

I don’t think that the TIPS market is pricing in zero real GDP growth over the next 5 years. But I do think it reflects worries over stock-market valuations. A stock-market investor only gets exposure to the economy’s performance via investing in equities if p/e ratios don’t fall, after all, and I can easily imagine a scenario where the economy grows modestly, or enters a shallow recession, while stocks fall significantly.

So 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.

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Comments
14 comments so far

“I don’t think that the TIPS market is pricing in zero real GDP growth over the next 5 years.”

No; they’re probably pricing in a few quarters (years?) of negative growth and netting to around zero.

“even these long-dated TIPS stand to drop quite a lot in value if they revert to their mean yields.”

From your mouth (fingers?) to G-d’s ear (eyes?), Felix, but reversion to their mean yields also implies reversion to mean growth expectations. That would be nice, but doesn’t seem the way to bet in the next year or two, which affects the five-year plan rather significantly.

Posted by klhoughton | Report as abusive

Might this have something to do with the fact that TIPS cannot fall below par value, so an investor in these will give some value to the guarantee of receiving at least par back at maturation? And the more one fears deflation the more one values that put… not my area of expertise, but I bought some when thinking about it this way.

Posted by TRKAdvisors | Report as abusive

“So 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. ”

I think that is an excellent statement. TIPs are the the only asset class of major size which does not have principal risk (at maturity).

This is what the world looks like with large savings and no place to put the savings. There is an enormous temporal mismatch between present positive savings around the world and strong future demand. As both the developed and advanced emerging worlds are aging, there is a fierce struggle for claims on future output. Aging powerhouses like Japan and Germany especially, but also China and America’s boomers, are accumulating huge ‘savings’ but this savings does not usually consist of real assets. Instead it is usually claims on future tax dollars in different nations, claims that will have to compete against future entitlements (enormous) and other government costs. Further these claims will have to paid by a demographically shrinking and rather restive tax base.

TIPs are the only future claim that promises to keep its real purchasing power at maturity.

Posted by DanHess | Report as abusive

@TRKAdvisors,

Yes, TIPS have embedded floors on the principal (but not the coupons.) These options are now ATM and consequently of non-negligible value. The higher yield of 10Y over 5Y TIPS therefore conflates the higher relative value of the floor in the 5Y case with the term-structure of real yield.

The term structure of CPURNSA zero-coupon swap rates (quoted on BBerg) is probably more reliable if you want to isolate the latter effect.

Posted by Greycap | Report as abusive

negative real yields on TIPS have been relatively common at shorter maturities than 5 years, but we have been close to these levels before this crisis. In the spring of 2004, 5y real yields got pretty close to zero (~32 bps). All I read into it is that after a couple of years of the Fed holding short term real interest rates below zero without much impact on growth or inflation, the market now recognizes that short term real rates will need to be negative for a long time to revive the economy. A 5y TIPS with a negative real yield is just an extrapolation of negative short term rates well into the future, which doesnt seem unreasonable (esp when you get it in an instrument that compensates you if inflation spikes).

Posted by siraca | Report as abusive

Just eyeballing it, the mean yield on the 10 year TIP looks about 2%, and right now it’s at about 1%. Even if yields do mean revert, since the duration on the 10 year TIP (caveat: duration is especially tricky with TIPS) is about 5, the loss would be about 5%. I call that cheap insurance, given that that the explicit intent of QE is to bring about the insured event — inflation. Plus, you get the upside if inflation takes off. This isn’t a “nothing a else to buy trade,” it’s a don’t fight the FED trade, TIPS edition.

Posted by maynardGkeynes | Report as abusive

“As both the developed and advanced emerging worlds are aging, there is a fierce struggle for claims on future output.”

DanHess nailed it. Plenty of capital swimming around, no good places to invest it. Or rather, the uncertainty of the present environment pushes an inordinate proportion of the money towards the low-risk end of the spectrum. Hard to get any lower-risk than TIPS.

I’ve owned TIPS myself over the last 3.5 years, and while I would love to sell at the presently inflated valuations, where else can I put that segment of the portfolio? There doesn’t seem to be sufficient economic clarity to put EVERYTHING in stocks. Straight cash, at zero interest? Gambling on commodities?

So TIPS it is… Mostly longer terms than 5y, at least.

Posted by TFF | Report as abusive

“As both the developed and advanced emerging worlds are aging, there is a fierce struggle for claims on future output.”

DanHess nailed it. Plenty of capital swimming around, no good places to invest it. Or rather, the uncertainty of the present environment pushes an inordinate proportion of the money towards the low-risk end of the spectrum. Hard to get any lower-risk than TIPS.

I’ve owned TIPS myself over the last 3.5 years, and while I would love to sell at the presently inflated valuations, where else can I put that segment of the portfolio? There doesn’t seem to be sufficient economic clarity to put EVERYTHING in stocks. Straight cash, at zero interest? Gambling on commodities?

So TIPS it is… Mostly longer terms than 5y, at least.

Posted by TFF | Report as abusive

Dan Hess nailed it, “This is what the world looks like with large savings and no place to put the savings.”

We’ve seen one bubble after another in the last decade, first the tech stocks, then real estate, now bonds. Too much capital chasing too little growth.

That is bad news for those who wish to hold down tax rates on the wealthy, since the principal argument is that by providing capital the wealthy create opportunity for the masses. If the system is in fact awash with investment capital, then I see no reason why we should limit the tax base to create more. At the very least, they ought to face the same 50% marginal tax rate on their income that working professionals do. (Federal income tax plus FICA plus state income tax plus withdrawn tax credits.)

Posted by TFF | Report as abusive

By buying sovereign debt everywhere, a high-saving world is dumping its investment decisions on governments. Real nice. If the savings isn’t invested well by governments, an attempt to extract that savings will result in a sovereign debt crisis and perhaps big inflation.

Governments, should they be good stewards of those savings, ought to find places to invest that yield returns in the future. If savings are instead dumped into present spending as we now see, that savings is destroyed. There are some places where governments can actually spend without entirely destroying capital: research into alternative energies, education, infrastructure that will aid economic growth and such. If nuclear power plants are economical but beyond the time horizon of capital markets, why not finance some with government money? Then at least the capital entrusted with the government will not be totally vaporized.

What about stockpiling commodities? If we are headed toward a world of commodity scarcity, that is not a bad idea.

Why is it that the Chinese government is investing in all these capital-preserving things while ours is just destroying savings by dumping it into present consumption?

Posted by DanHess | Report as abusive

By buying sovereign debt everywhere, a high-saving world is dumping its investment decisions on governments. Real nice. If the savings isn’t invested well by governments, an attempt to extract that savings will result in a sovereign debt crisis and perhaps big inflation.

Governments, should they be good stewards of those savings, ought to find places to invest that yield returns in the future. If savings are instead dumped into present spending as we now see, that savings is destroyed. There are some places where governments can actually spend without entirely destroying capital: research into alternative energies, education, infrastructure that will aid economic growth and such. If nuclear power plants are economical but beyond the time horizon of capital markets, why not finance some with government money? Then at least the capital entrusted with the government will not be totally vaporized.

What about stockpiling commodities? If we are headed toward a world of commodity scarcity, that is not a bad idea.

Why is it that the Chinese government is investing in all these capital-preserving things while ours is just destroying savings by dumping it into present consumption?

Posted by DanHess | Report as abusive

DanHess, consumption in China is growing quite rapidly. Consumption in the US is not. The US government is borrowing heavily to support consumption because the alternative is falling consumption. China has a rapidly expanding economy and is working to WITHDRAW money from consumption to keep it from expanding too rapidly.

Different countries, different situations.

Posted by TFF | Report as abusive

China has too much consumption? That is not what Michael Pettis thinks…

http://mpettis.com/2010/08/chinese-consu mption-and-the-japanese-%e2%80%9csorpass o%e2%80%9d/

“As I have discussed before, in order to rebalance the economy China must sharply raise the consumption share of GDP. It has declined from 46% of GDP in 2000, which was already a very low number, although not quite unprecedented, to 41% in 2003, which is, I believe, an unprecedented number, at least for any large economy.

But that wasn’t the end of the story. Consumption declined further as a share of GDP to an astonishing 38% in 2006, finally to end under 36% in 2009. I don’t think we have ever seen anything close to this level before.”

The US continues this macabre dance with China, where they who are far poorer than us send us their savings, which we promptly burn. Because the price of our bonds looks steady right now, they relax and surely imagine that they can get their money out at a future time. They cannot get their money out in real terms because we spent the money, thank you very much. It is not laying around anywhere.

Inflation or deflation, America cannot pay back its bonds. It has too many obligations to its own people, and it is a democracy. To pay back our debts without inflation would send us straight into depression. It’ll be either a haircut on treasuries or inflation. There is no other way.

If bondholders are fine with never cashing in their bonds, then, cool.

Posted by DanHess | Report as abusive

DanHess, China is going into this with open eyes. They understand the situation at least as well as you and I do.

Their growth was initially built on exports. Over the last decade they’ve been funneling much of that back into infrastructure. Consumption is increasing — quite rapidly — but not nearly as fast as production. They need a market for that production, and so they purposefully drain money from the economy to prop up the dollar and US bonds.

Eventually their economy has to be rationalized, with domestic consumption rising and (perhaps) production falling. They are supposedly backing off from their currency manipulation, while taking some of their less efficient production facilities off line. Meanwhile their domestic consumption will continue to grow.

They are walking a fine line to keep things moving in the right direction, while not pushing them too fast. Keeping that balance is far more important to them than whether or not they see a profit on those Treasury bonds. If they misstep, you’ll see a crash in exports, falling GDP, and widespread unemployment. While that would effectively increase consumption as a percentage of GDP, it isn’t the desirable solution.

For this reason, I have zero fear that China will dump their Treasury holdings any time in the near future. They could conceivably do that AFTER they’ve transitioned to a sustainable domestic economy, but for now their economy is dependent on ours.

Posted by TFF | Report as abusive
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