Day: March 6, 2008

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No, You Should Worry About Negative Short TIPS spreads

From four years and shorter, the yields on TIPS reflect a belief that nominal inflation measured by the unadjusted CPI will exceed the yields on nominal treasury bonds. This should come as no surprise, except that it was so slow in coming. The CPI has been running at 3-4%+ annualized for some time now, and the sleepy TIPS market continues to estimate a 2-3% short-term CPI. That, in the face of a rising CPI. (Hey, a reason to buy TIPS! The actual inflation accretion is high than the implied accretion.)

Consider the following graphs:

Source: Federal Reserve, David Merkel

The first chart shows the TIPS-derived inflation breakevens taken from the smoothed series that the Federal Reserve puts out. It is interesting to note that the breakevens today are still below peak levels reached in 2005 and 2006. The second chart takes the breakeven rates to maturity, and calculates the forward breakeven inflation relationships. In this case, the forward breakeven rates have been rising, particularly between five and ten year out, though they are still not at record levels.
The third chart looks the forward inflation curves at five special points in time:

  • 8/24/04 ? Widest spread between expected five-year inflation, and ten-year inflation, ten years forward
  • 9/9/05 ? Largest inversion of the spread between expected five-year inflation, and ten-year inflation, ten years forward
  • 6/29/06 ? End of the tightening cycle, as I date it
  • 8/10/07 ? Beginning of the loosening cycle, as I date it
  • The present

The present environment is unusual because of the relatively large difference between two-year inflation five years forward, and three-year inflation seven years forward. The logical play would be to go long seven-year TIPS, and short seven-year nominal Treasuries. As views on future inflation shift higher, the low implied rate of inflation in the seven-year part of the curve should adjust to the higher inflation forthcoming.

Now, why should the negative TIPS yields on the front end be a concern?? Negative real yields, which are even more negative if trailing actual CPI figures are used, indicate even more inflation to come.? Does this mean sell equities?? No, but don’t hang out in long bonds.? Keep your bonds short, and maybe buy some TIPS, say, 15 years out.? Hedge by selling nominal Treasuries short, if you like.? Negative real yields are a sign inflation is likely to accelerate, particularly when the Fed is showing no signs of raising? rates, but has further decreases coming.

Can You Carry The Position?

Can You Carry The Position?

My post yesterday on corporate bond spreads was received well.? I want to amplify one point that I did not make strongly enough.? During market crises, asset values cheapen not only in response to likely losses over the long run, but the possibility that there might be forced sellers due to:

  • Reduction of leverage because of asset values declining
  • Reduction of leverage because of brokers lending money get skittish
  • Reduction of leverage because of rating agency downgrades
  • Reduction of leverage because of client withdrawals
  • Reduction of leverage because of an increased need for capital from the regulators
  • Arbitrage from falling prices in related markets

This can temporarily self-reinforce falling asset prices, until unlevered (or lightly levered) buyers find the returns from the assets to be compelling.? Though my piece yesterday was more fun to write, this makes the argument plain.? Can you carry the asset through hard times?? What about the rest of the asset holders?

The concept of weak hands versus strong hands is a very real issue, and for those with a subscription to RealMoney, I recommend these four classic (Labor of love) articles of mine:

Managing Liability Affects Stocks, Pt. 1
Separating Weak Holders From the Strong
Get to Know the Holders? Hands, Part 1
Get to Know the Holders? Hands, Part 2

These articles are core to my thinking, and I spent a lot of time on them.

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