Deflation and negative TIPS yields

By Felix Salmon
August 13, 2010
Vincent Fernando today says that "Actually You Should Panic" if TIPS yields go positive. His argument: "if TIPS yields hadn't fallen to where they are now, then we'd truly have something to worry about -- Deflation."

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In one of those classic understated TBI headlines, Vincent Fernando today says that “Actually You Should Panic” if TIPS yields go positive. His argument: “if TIPS yields hadn’t fallen to where they are now, then we’d truly have something to worry about — Deflation.”

The problem is, Fernando’s math doesn’t add up. Expected annualized inflation, over the next five years, is equal to the yield on 5-year government bonds, minus the yield on 5-year TIPS. (We’ll ignore things like the liquidity premium for on-the-run Treasuries.) The 5-year Treasury bond is currently yielding 1.47%, so if the 5-year TIPS yield is slightly negative, that puts expected inflation at about 1.5%. On the other hand, if the 5-year TIPS yield were up at 0.5%, then that would put expected inflation at 1%. Which does not count as Deflation, and is certainly nothing to Panic about.

Of course, it is a bit more complicated than that. For one thing, we’re talking about average inflation over five years, which given that inflation rates tend to bounce around a bit, might well mean a brief amount of time in negative territory. But that, again, isn’t the kind of deflation to panic about.

Meanwhile, 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.

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