My TIPS, Treasuries, and Inflation Model — III

TIPS Treasuries and Inflation Model 3

Personally, I don’t think it is a big deal that the Fed raised the discount rate.  The discount rate plays a small role in monetary policy.  I do think that the record steep yield curve is the bigger story.

The forward Treasury yield curves at present are telling a story.  Here are the main ideas of the story:

  • Short interest rates will rise dramatically for the next 15 years then decline dramatically.
  • Same for inflation rates, but make that 17 years.
  • Real short-term rates peak 12 years out, but the same story.

For proof, look at these graphs that summarize the results of my model:

If you think short term inflation rates will be lower in the short run, then short short TIPS and go long nominal short bonds.

If you think that long inflation rates will be higher than the models indicates, then short long nominal bonds, and go long TIPS of similar maturity.

But after all of this I would simply say that the upcoming offer of the 30-year TIPS looks fairly priced in the “when issued” market.  I look forward to the issue of the 30-year TIPS, and I know it will improve my model.

12 Comments

  • Greg says:

    David — TIPS do not track inflation, they track CPI.

    CPI is not inflation — it says so right on the BLS website.

    If one is trying to defease retirement liabilities, you have to defease your actual cost of living changes, not imaginary government statistics.

    If your investments do not earn a yield (after taxes) that is at least equal to your cost of living increase — you are falling behind; you are losing money.

    I don’t know anyone who’s cost of living is correlated to CPI.

    During the last 30-40 years, most employment contracts have been implicitly or explicitly tied to CPI — but pay has not kept pace with the cost of living… this basic problem led many people to use their house as an “ATM machine”, etc.

    Buying TIPs for your investments is like tying your pay to CPI — you will not keep up with your cost of living, much less earn any profits

  • Greg, the CPI is a measure of goods price inflation. I have written about the deficiencies in the CPI. It undermeasures goods price inflation by 1-2%/year, but it is a good proxy for the trend.

    It is *not* monetary or asset inflation, that is certain.

    TIPS can be very good investments — you just have to use them at the right times. I have done well with them. After all, there is falling behind, and falling behind by more.

  • Kolya says:

    Hi David,

    Thanks for the graphs. I get a bit confused by the terms forward and spot. I assume spot implies what the instantaneous short term interest rate will be at various points in the future. In one of your previous posts you also gave a graph of equivalent zero coupon rates which I find easy to understand.
    Forwards still confuse me.

    It would help me if you could put in a legend for engineering types instead of financial types.

    BTW I assume you find the current 5 year TIPs to be fairly unattractive. I hesitate to buy longer dated ones because I think long real rates have got to climb.

  • Greg says:

    David — I would agree there are times when a CPI indexed floater (which is what TIPS essentially are) might be a good investment. And TIPs might be more / less attractive on a relative basis to nominal Treasury bonds

    But that is not the same as saying “If you think that long inflation rates will be higher than the models indicates…”

    It might be more accurate to say “If you think the government will report higher CPI numbers than the model indicates…”

    Also — TIPs do not have the same liquidity as nominal bonds, and they are generally not used for hedging

    Is that illiquidity the source of TIP relative performance at times to nominals?

    REFCO strips often trade at a good discount to nominal strips, even though they are (credit-wise) exactly the same as US Treasuries. But they are a buy and hold to maturity investment, not a trading vehicle like Treasuries

  • I agree with you technically, but sometimes I don’t write with precision because many refer to the CPI as inflation.

    As for liquidity, yes, that is a difficulty. For example:

    http://alephblog.com/2008/11/26/the-occasional-seemingly-free-lunch/

    But TIPS are pretty liquid, though not compared to nominals. Good managers get better execution than the posted spreads with their institutional brokers, unless they are buying a disproportionate amount of the bonds available.

  • Kolya — the spot curve gives the yield for a zero coupon bond. One payment out in the future.

    The forward curve gives us the estimate of where short interest and inflation rates will be in the future.

    The coupon curve gives us the yields for bonds pricing at the same price as the principal paid at maturity.

    As for the 5-year TIPS — the question is, do you think the CPI will grow more than 2%/year over the next 5 years. I think the answer to that is yes, but I am still ruminating about how I think policy will be applied here.

  • Ted K says:

    Mr. Merkel, I just wanted to say I appreciated your visit and comment on my blog the other day. I can’t compare myself to the “heavy-hitter” bloggers, but when someone like yourself visits and comments it means a lot to me. I do know that that particular issue of 401k plans is kind of dated—but nonetheless there are millions of people still being duped by those fees and I feel it’s an issue that cannot be driven into the ground enough when people are losing retirement savings so multi-national conglomerates can add another decimal point to their years profit margin.

    I hope you will visit again and give me a pat on the shoulder if you thought the post is good (or a constructive criticism). Thanks, Ted K

  • Greg says:

    David — the reason I nit-picked about the inflation versus CPI distinction is because of the government policy implications.

    After the Boskin Commission in the 90s and all the somewhat arbitrary “hedonic adjustments” in the years since, the government has shown a willingness to redefine CPI to a lower and lower number.

    Understating goods inflation by 1-2% per year, compounded over time, quickly adds up

    While Paul Volcker has talked about the need to significantly postpone the social security retirement age, most politicians have been timid at best. Bribe the voters now, and let the next elected official worry about the shortfall.

    “inflating” away social security benefits (by under-reporting CPI) has become the defacto policy of the Federal government (both parties)

    While I agree with you that “goods inflation” is likely to accelerate — that doesn’t mean CPI will show it. The “leaders” of our country must deal with a soon pending cashflow bankruptcy of Social Security. They don’t seem to have the courage to admit this problem, much less do anything about it.

    Continuously redefining CPI to under-report goods inflation, and thus inflate away some social security obligations, has been the unofficial policy for decades.

    I have no idea how to price that risk into TIPs — but I suspect the embedded “inflation definition option” that the government holds may explain much of their apparent yield advantage.

  • Greg, I created this model because there is a lot of “TIPS mandates” out there. My firm is looking for business opportunities.

    On inflation, I wrote this piece at RealMoney:

    http://www.thestreet.com/p/_rms/rmoney/davidmerkel/10185823.html

  • Lurker says:

    @ David –

    From the graphs, there seem to be two places to be and one place NOT to be.

    For a 2-3 year trade it seems to be 10-20 years, a curve flattener. Yield capture and possible cap gains as the short end moves up and the curve flattens. This is in line with my own modeling.

    For holding to maturity, it looks like your graph places that at 20+ years. Which is probably four business cycles and 2-3 recessions worth of holding, LOL!

    The place to NOT be, from your graph, is below 3-4 years. Oddly and sadly, that’s exactly where most insurers are putting their T money to work today.

    @ David –

    “TIPS mandates?” That’s one of the stupidest ideas I’ve heard this week. How could they be that dumb? Oh wait, they’re all pushing low duration now …

    TIPS are a solution in search of a problem IMO.

    @ Greg –

    Yes, properly spoken, inflation is monetary and CPI is a COLA, where COL is a PRODUCT of monetary inflation once it’s filtered through a Cantillon effect. And some people, including David and sometimes even myself, get sloppy with the language. It’s hard not to, since the vernacular equates the two terms.

    Understand that the mandate of CPI, a “constant standard of living index of price,” is virtually impossible to fulfill. You can’t hold the standard constant for more than a few years, and you can’t measure the improvements in standard with pricing terms.

    I have problems with some, but not all, of the hedonic adjustments. Many are NOT arbitrary. Some, like adjusting the price of a particular unit of housing UP because of the aging (and hence, deterioration) of that particular unit, work counter to your implication that all hedonics hold prices DOWN. I don’t mean to imply that their methods are perfect, for example, I think they handle vehicular hedonic adjustments very poorly and I totally despise their use of multivariate regression in hedonics, but overall, I’ve looked into it and it’s not as bad as you seem to think.

    The shadow stats guy has an agenda and a product to sell, and IMO he’s exaggerated the problems by several orders of magnitude.

    You and he might both want to take a look at CPI over decades. Even in the OLD series, there were periods of time with PERSISTENT LOW CPI YEAR-OVER-YEAR CHANGES. By “persistent” I mean “decades.” So the current period is not without precedent, and if you carefully look at the changes in method from the nineteen-teens through today, you’re bound to find a lot of things you will view as outright improvements.

    IMO, CPI changes over short periods (years)will be off of the average COLA they’re intent on measuring, but I don’t seriously think, over long periods like decades-plus, that they’re systematically OVER or UNDER estimating COLA.

  • Lurker says:

    Oh, how I hate to double-dip. But this hit me after posting …

    Several prominent bloggers, some years ago, attacked the use of “owner’s equivalent rent” in the CPI, saying it held CPI down from actual costs, because homes were escalating in price so quickly.

    I haven’t checked, so maybe you could research this and get back to me …

    Now that housing prices have utterly collapsed, are those same prominent bloggers now attacking the use of “owner’s equivalent rent” in CPI for holding the implied cost of housing UP?

    Which is an illustration of my point; the methods are imperfect, yeas, especially over short time periods, but I find it doubtful that they have a measureable long-term (i.e. multi-decadal) bias in either direction.

    Which is, by way of disclosure, an opinion I’ve come to only recently, after many years of looking at this issue, and after previously holding views very close to Greg’s.

  • Greg says:

    @Lurker — everyone is very impressed with your mastery of CPI minutia. Getting your opponent bogged down in arguing tiny little details is a classic political technique. While you quibble over what fungus is killing this one tree, you don’t notice the whole forest is on fire. Politicians and trial lawyers love you.

    There is no way to check your “multi-decadal bias” theory, both because the definition of CPI has changed repeatedly and because you don’t have a “correct” index to compare it against… which is the reason people use CPI even though they know it is wrong (no alternative).

    Also, there is no such word as “multi-decadal” in the English language. You can’t argue the nuances of CPI definition with any credibility if you are going to be making up words like George W Bush.

    I challenge you to go re-read my posts and show where I even mentioned this shadow stats guy — you are the first commenter to bring him up.

    If you want to argue against my post, feel free. If you want to argue against this “shadow stats” guy, feel free. But your efforts to claim his arguments as mine, and then refuting this fraud is ridiculous. Figure out who you are arguing with or else don’t post.

    Returning to the actual discussion, not your meanderings — my argument was and still is:
    The average person’s compensation is not keeping pace with their cost of living.

    If one’s investments also do not keep pace, you are in serious trouble. If one is buying TIPs under the guise of “inflation protection” — TIPs have not provided such protection at all

    Actually, if you exclude the first 2-3 years after their introduction (in 1997-1999 when they were clearly mispriced) — TIPs have been either an average or a lousy investment.

    That does not mean David (or whomever) might have jumped in/out of them on a trading basis and made some money — it means long term holders have at best broken even versus nominals, and have generally lost versus their actual cost of living.

    BTW David — now I understand why you were trying to make this model… it seemed a little out of character for you. The customer wants what the customer wants though.

    I have wondered whether committee supplied asset allocation percentages cause a lot of mispricing — as these investment committees are usually guilty of herding / group think on a grand scale.