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John Hussman's Weekly Market Comment yesterday advised selling TIPS.

August 15, 2011

Two One-Way Lanes on the Road to Ruin

John P. Hussman, Ph.D.


In the investment markets, we view securities as claims on a long-term stream of cash flows that will be delivered to investors over time. It is that stream of deliverable cash flows, not next year's predicted operating earnings, and certainly not the market price of the security itself, that actually forms our view of "value" that is intrinsic to each security. ...

...all of us are presently benefiting from the continued demand for default-free securities (specifically, U.S. base money and Treasury debt - which I do continue to view as default-free). ...

In bonds, we saw a nearly parabolic surge in long-term inflation-protected Treasury securities [TIPS] last week, bringing long-term real yields to a fraction of a percent. We used that spike to liquidate the majority of our holdings in that area. ...
[end quote]

The yield of the 10-year Treasury has been falling off a cliff. Ditto the 10 year TIPS. The yield of the TIPS has gone negative.$TNX

A negative yield on the 10-year TIPS is only reasonable (aside from short-term speculators and/or interest-rate insensitive buyers) if the 10 year average CPI-U is less than zero -- that is, if the U.S. enters a deflationary recession.

I bought 10 year TIPS during the crisis of late 2008, when the yield on the TIPS was higher than the yield on the Treasury of the same duration. This was equivalent to the market saying that there would be deflation (negative inflation) over the next 10 years.

In June 2011 (the latest available data), the annualized increase of CPI-U was 3.6%, on a rising trend.

Why would an investor prefer TIPS to Treasuries?

If the investor expects the future inflation rate to be higher than the Treasury-TIPS spread on the purchase date, the investor would prefer TIPS.

From the very first TIPS record (January 2003) until September 2008, 12-month CPI-U inflation was almost always higher than the Treasury-TIPS spread. The average inflation was significantly higher than the average spread.

Pre-crisis (Jan-03 to Sept-08)

TIPS Treas Spread Inflation
Min 1.09 3.33 1.61 1.4
Max 2.69 5.11 2.71 5.4
Avg 1.99 4.32 2.34 3.11
StDev 0.34 0.41 0.24 0.95

During the financial crisis, TIPS yielded more than Treasuries, an indication that the market expected deflation. In fact, there were 6 months of deflation during the crisis. However, I expected inflation over 10 years, so I bought TIPS in November-December 2008.

The yield of the 2018 TIPS when I bought them in December 2008 was about 2.75% + CPI-U.

After the crisis, the wild fluctuations settled down. Between January 2009 and the present, the TIPS yield declined faster than the Treasury yield.

Post-crisis, Jan. 2009 - present

TIPS Treas Spread Infl Spread-inflation
Min 0.53 2.52 0.61 -2.1 -1.36
Max 1.91 3.85 2.60 3.6 3.84
Avg 1.26 3.23 1.96 1.07 0.92
StDev 0.41 0.40 0.44 1.58 1.32

From January 2011 to July 2011, the yields have been parallel: the Treasury-TIPS spread has been in a tight range.


Are TIPS overpriced relative to Treasuries today?

The entire Treasury yield curve has dropped and flattened in the past couple of weeks. This is a common indicator of slowing economic growth (also of flight-to-safety buying due to the European sovereign debt problems).

The yield of the 10-year TIPS today is 0.02%. The yield of the 10-year Treasury today is 2.27%. The spread (implied 10-year inflation rate) is 2.25%. That is close to the long-term average spread of 2.45%.

If inflation does not moderate, the real 10 year Treasury yield will remain negative.

TIPS are behaving normally relative to Treasuries and relative to their history. Historically, actual inflation has been higher than the Treasury-TIPS spread, so TIPS owners have benefited.

Conclusion: I would not buy TIPS at this time, but I don't see a compelling reason to sell my "crisis" TIPS. I do expect higher inflation in the future.

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