Nouriel Roubini and other prominent economists have argued for aggressive measures to head off an impending deflationary disaster. As evidence of this looming threat, these doomsayers are pointing to the yield on 5-year TIPS (Treasury Inflation Protection Securities) relative to the yield on 5-year traditional Treasury notes. TIPS typically offer a lower yield than conventional bonds because they also adjust both principal and interest payments with inflation; the adjustment factor, which changes daily and is based on the CPI, is known as the index ratio. The difference between equivalent maturity TIPS and conventional treasuries is said to be a measure of the market’s expectation for inflation.
For several weeks at least, the traditional relationship between TIPS and conventional treasuries has been inverted. TIPS actually yield more than government bonds with fixed interest rates. Roubini has been vocal in identifying this as a critical piece of evidence: “the TIPS market is now signaling that investors expect inflation to be negative over the next five years, as a severe recession is ahead of us.” Although Roubini’s economic outlook may, or may not turn out to be correct, he is wrong to point to TIPS as evidence of a long-term deflationary trend.
What the doomsayers are missing is that TIPS may anticipate expected changes in price levels in different ways. To start, the crucial index ratio by which TIPS are adjusted lags actual CPI by three months. Sophisticated market participants therefore know with certainty what the index ratio will be in three months. In most environments, the rate of consumer inflation varies little over a 3-month period and would have little impact on the “inflation reading” offered by TIPS. However, we live in unusual times.
The collapse of commodity prices has changed this game dramatically. The current TIPS index ratio, because of the 3-month lag factor, is tied to a CPI that is likely to be close to the high water mark for some time. Regardless of whether we have a sharp recession or a shallow recession, the CPI will come down as the sharp decline in commodity prices filters through to the CPI. The chart below shows a five year history of the CRB futures index, a good proxy for commodity prices. Buyers of TIPS know with near certainty that the CPI will decline over the short term to reflect today’s reality of lower commodity prices. TIPS pricing must reflect today’s knowledge even though one of the technical aspects of their structure, the index factor, is based on information known to be outdated. A proper analysis needs to incorporate this dichotomy.
With the insight and collaboration of my friend, economist Stan Carnes, I analyzed both the much-discussed 5-year TIPS, as well as the 10-year security. In each case, we made one critical assumption, namely that the index ratio would reflect a CPI that will have declined by 6% over 6 months. Given commodity prices have reversed over half a decade’s gains in a matter of months, this seems if anything, a conservative assumption. Holding the dollar investment in TIPS constant, we adjusted the current index ratio down 6%, set the date forward by 6 months and solved for yield (prices as of 11/14/08).
The 5-year conventional treasury (2.75% of 10/13) yielded 2.33%, while the 5-year TIPS (0.625% of 4/13) yielded 2.41%, on the surface suggesting a long-term flat/deflationary outlook. However, making the above commodity-linked adjustment to the index ratio and looking out 6 months, the 5-year TIPS yield is 1.28%, suggesting a more realistic long-term inflation expectation of 1.05%.
Going through the same exercise with the 10-year securities shows a similar, if less dramatic pattern. On the surface, the comparison between TIPS (1.375% of 7/18) yielding 2.84% and the conventional note (3.75% of 11/18) yielding 3.74% appeared to suggest a very low inflation rate of 90 basis points. Adjusted by the same hypothetical 6% drop in CPI over 6 months, the TIPS yield is 2.43, implying a higher long term inflation rate of 1.41%.
This analysis, particularly for the shorter maturity TIPS, is sensitive to assumptions regarding expectations of the impact of today’s lower commodity prices on CPI over time. To the degree the expected adjustments to the index ratio are greater, the larger the actual implied inflation rate. In addition, the 5-year comparison may also be skewed by the general flight to quality and liquidity which has beset the short end — this would no doubt lower the conventional bond yield more than the TIPS, further distorting the apparent “deflation” reading.
Regardless of these technical aspects, the point is that TIPS are not clearly signaling frightful deflation. Based on reasonable expectations, the TIPS/Treasury inversion can be seen as a reflection of today’s commodity prices rather than tomorrow’s deflation. Before our policymakers embark on the type of fiscal spending spree that true deflation might warrant, we need to get our facts straight.