I spent some time today updating my Treasury yield curve and inflation model.? Anytime a new Treasury note/bond is issued, or we get a new CPI figure, or a coupon payment date passes, the model must be updated.? Though I made some technical improvements to the program at the same time, what impressed me was the change in the forward inflation curve since I last wrote on the topic less than a month ago.
The big change is that inflation expectations rise? continually out to? 2038.? Now the TIPS curve only goes out to 2032, so the extrapolation should be discounted.? But the last time I wrote, inflation expectations peaked in 2022.? That is a significant change.? Investors have bid up the prices of long duration TIPS, to the point where I would be skittish about buying the long end of the TIPS curve.
Okay, let me post the graphs:
Using closing prices, here is my estimate of the coupon-paying yield curve:
And here is the spot curve (estimating where zero coupon bonds would price):
And finally, the forward curve, which estimates the expectations of future short-term rates, inflation, and real rates:
My model uses the whole Treasury and TIPS markets to estimate yields and inflation expectations.? Here is what is notable:
- Inflation expectations on the long end have risen considerably over the last month.
- I suspect that the US Treasury will be able to issue 30-year TIPS at yields lower than 20-year TIPS.? The new 30-year TIPS issue in February will prove me right or wrong.
- Real forward yields are lower than zero 27 years out — that is unlikely.? I would expect nominal forward rates to rise on the long end.
There are at least two ways to view this situation:
1) Investor inflation expectations have overshot, and it is time to sell long TIPS and buy long nominal bonds, as long-term inflation expectations may fall in the future.
2) Time is running out — rapidly rising long-term inflation expectations indicate that the average investor does not trust monetary policy to succeed over the next 20+ years.
What would I do here?? I would hedge my bets, and buy some long Treasury zeroes (not a lot), mostly intermediate-to-long TIPS, and some short nominal Treasuries.? I would bias the portfolio in favor of bonds that are seemingly underpriced.
The hedged position is because I don’t know which direction the US Government and Fed intend to go with policy.? They likely have no idea as well; this is a tough situation.
On the deflationist side there is Hoisington, Gary Shilling, Carpe Diem.
More inflation-oriented are Greg Mankiw, Tim Duy, and Pimco.? But I don’t see anyone of significance screaming for high price inflation in the long-term future. Yes, that is the default view of much of the financial blogosphere, but the US Government had that option in the ’30s.? It would have made things a lot easier if they had done it, but they didn’t do it.? They acted in the interests of the wealthy, rather than the interests of the economy as a whole.
That’s what makes my model interesting.? It shows that there is a lot of demand for long TIPS.? If the US Treasury thinks it can get things under control, the rational thing to do is to stuff the long TIPS buyers with as much product as they can gulp before it becomes obvious that low inflation will continue because the government will soon balance the budget and pay down debt, as they did after WWII.
But if the US Treasury can’t get things under control, the long TIPS buyers will do well, as they have the most sensitivity to rising forward inflation expectations.
Where do we go from here?? My guess is slowly rising inflation with a weak economy.? But so much depends on the rest of the world, that I hold that opinion skeptically.
Full disclosure: I own some of the Vanguard TIPS fund [VIPSX].
Hi David,
Interesting results, thanks for sharing them. One suggestion that I would make for how to share the display of your results is to add in the previous month’s curve into the Forward Yields chart, so that one can see how real forward yields have shifted. And, after you’ve accumulated six months or a year’s worth of data, perhaps you could add that also.
Thanks again,
Steve
Not sure I understand the appeal of TIPS as long-term inflation protection. Isn’t this like asking the fox to guard the henhouse?
http://www.ritholtz.com/blog/2010/01/why-michael-boskin-deserves-our-contempt/
It would seem to me a more effective approach would be a “reasonable” allocation to commodities and precious metals where you know for certain you are getting the inflation protection you are paying for. Reasonable people could disagree on what a reasonable allocation is.
Hussman had some interesting comments/analysis on inflation this week, particularly that it is FISCAL policy not monetary policy that drives inflation. Any thoughts on that distinction, David?
BTW, keep up the great work. You are one of the most thoughtful, balanced bloggers out there.
What are your thoughts on this market cycle so far, and I know you don’t have a crystal ball; talking probabilities here. Massive bear market rally topping out here? Or just the beginning of a cyclical bull ala 2003-2007. What are your thoughts on market valuation? All the long-term cyclical stuff, Tobins Q, Shiller P/E, Hussman price to peak all say pretty darn overvalued while the Fed model and its million variants all say reasonable valuations. That said, the last market cycle shows the market can depart from those longer-term cyclical metrics for a long time, but do seem to eventually make the round trip back.
Nice work and fascinating results.
Is there any chance of you actually publishing the formula which generated those curves? Feel free to leave out anything which would enable someone to duplicate your estimation methodology …
I would also be fascinated to see how the parameters in your model changed over time if you went back and ran them off of various historical datasets (provided the TIPS data was available of course).
Thanks again.
Mark, in my last post, in the comments, the formula is there.
David – thank you again for sharing this model in your earlier post.
I would suggest you need to consider an alternate explanation for the “rising inflation expectations” out past 2032:
The US government is practically guaranteed to default.
Given the liars that inhabit Congress and the White House (both parties), the default will most likely be a technical default and not a literal refusal to pay.
Even by the government’s absurd accounting, entitlement spending eats up the “trust funds” no later than 2032 (the same date as your model is coincidence). These “trust funds” are nothing but worthless IOUs from Congress, that can’t be redeemed for spendable cash. The Liars must raise new taxes and/or sell new debt to pay the IOUs to pay entitlements — which is exactly the same position they would be in if the “trust funds” did not exist. They are an accounting fraud, not trust funds at all.
But even if you considered these funds as something other than fiction — they run out by 2032 according to the GAO. They run out sooner by several third party calculations. By honest accounting, they don’t exist.
In 2009, Social Security spent slightly more than it took in — the first cash flow deficit in the program’s history.
Medicare is supposed to go cash flow negative this year, 2010.
Realistically, the government cannot cut off grandma and grandpa (at least not all of them).
Realistically, the government is going to have a tough sell taxing junior for a system that has 0% chance of being there later on — it amounts to an extra tax for anyone under age 50, which is age discrimination. Also, any faith in the system will be destroyed when Congress admits another government program is bankrupt (Social Security has been actuarially bankrupt since the middle 1970s)
Already, “wealthy” senior citizens have to pay higher Medicare fees. The definition of “wealthy” will get racheted down over time.
Benefits will become taxable for the “wealthy”, and later they will be means tested — wealthy citizens simply won’t get anything, which by the way will be a default on a promise. The Supreme Court ruled back in the 1960s that entitlements are not really entitlements, and Congress can change them at any time. Nice legal technicality, but a broken promise is still a default.
With almost the entire tax revenue taken up by entitlements and interest payments (leaving zero for Congress to bribe Nebraska with, never mind agriculture, defense, education, etc) — either interest payments or entitlements must be cut to make room for all the other things government supposedly does.
History shows that corrupt governments attempt to weasel their way out of spending problems by inflating the currency away.
Inflation is a technical default. You can put whatever lipstick on a pig that you want, but you are paying back your loan with something worth a lot less. Political spin doesn’t make this anything other than a default.
The US government has two choices over the next 20-30 years — default on promises made or default by inflation.
And the losers in Congress think they are going to create even more entitlements? They have no credible way to meet the promises they already made
Can you use your model to figure out what kind of inflation expectations people had in the 70’s when we were experiencing significant inflation? I ask that because I was trying to figure out what historical returns for TIPS bonds would like so I could put them in my mean variance optimizer.
I know they’ve stepped the limits down quite a bit on how much you can buy, but iBonds have some nice advantages for inflation protection that regular tips don’t have.
David,
While I share your reaction to overly strident inflation warnings, I think you dismiss the long-term inflation fears a little too easily.
James Hamilton is surely a serious economist (what is your definition of significant?), and there have been numerous posts at Econbrowser, the latest today, with worries about long-term inflation: “Inflation is not something you should be afraid of for 2010. But what we need is a convincing commitment from the government to both near-term stimulus and longer-term fiscal responsibility in order to be assured that it’s not a concern over the next decade.”
Greenspan’s 2007 book suggested the possibility of 10% Fed rates by 2030 (that’s both high and long-term), according to a 17 Sep 2007 Bloomberg article. At least some people take Greenspan to be a significant economist.
Buffett is surely a significant investor. He was quoted in May of last year: “one sure way to pay for excess spending is to inflate the value of the currency, Buffett said. … “My guess is the ultimate price will be paid by a shrinkage of the value of the dollar.” ”
Your point about the 30s is an important one, and I guess you know more about the 30s than I do. But isn’t there a big difference now in entitlements?
Probably one reason there are so many apparent differences on inflation is simply that different people have different time spans and definitions of “high” in mind. Maybe you have a different view of some of the above examples due to definitional difference.
Jim
ClearOnMoney.com
I follow Buffett. Early in his career he was obsessed with inflation. Read his first book to see what I mean. I would say it *was* his number one long time worry.
Now, he is not worried. He cites overcapacity like he has never seen before. At this point in his career, because he sits on top of a giant conglomerate, he is more in touch with the economy than ever. He pays a great deal of attention to his pricing power.
Do you know WHY he just doubled his position in Walmart? Because he likes how Walmart can exploit deflationary forces, i.e. twist the arm of suppliers to get lower prices.
—
I’m a “saver” first, and an investor second. My greatest fear is that my hard earned savings are inflated away. I think CPI-U is a joke. I started saving money in the mid-90s. I could buy a nice house for $200k in the mid-90s. Now, a nice house costs $1 million. A gallon of milk is still $2.50 … stuff like that is what cpi is tracking. CPI is why TIPs have only a limited value as comprehensive inflation protection… so don’t kid yourself that you’re fully protected.
Chris,
Thanks for the reply. I would certainly like to know it if Buffett has really stopped worrying about inflation. In this Dec 2009 video (http://www.youtube.com/watch?v=7uH3IUCBjug) he seems to me to be backing away from any talk that would destroy confidence, but still to be worried himself. But I admit he is not very plain. Can you point me to some strong evidence that he is not worried for the long term? (Of course overcapacity is the issue short-term.)
I agree that TIPs are not adequate protection. First, although I would agree with the BLS that CPI is a good approximation to one logical definition of inflation, it is clear that it does not keep up with the *current* standard of living (if you are curious to see my analysis, it is here: http://www.clearonmoney.com/dw/doku.php?id=public:cpi_and_cola). Second, the interest on TIPs is so low that it does not cover the tax on the imaginary profit due to inflation (which you must pay eventually, even if you hold the TIPs in a 401k).
I’m thinking commodities, utilities, and REITs are reasonable protection.
Jim
ClearOnMoney.com
Hi, I can’t point to strong evidence that he is currently not very worried about inflation over the long term. I know many smart investors are. Seth Klarman is a very smart, buffett-like investor and he is worried. But to twist your question… why is overcapacity necessarily a SHORT term problem?
I just attended a lecture by an analyst, Jeff Matthews, who wrote “Pilgrimmage to Omaha.” and I asked him about how I noticed Buffett’s change in fears on inflation. He agreed and confirmed that it’s because of his ability to see the overcapacity and lack of pricing power in all the industries he oversees.
If you want to read his early book that I mentioned about inflation, it’s The Warren Buffett Way, by Hagstrom. I just read Snowball. Not much inflation talk was in Snowball. What I remember as very odd about his early book was how he chose to buy stocks with inflation protection (like you’re thinking). You’d think he’d buy utilities, hard assets, etc. like you thought? Buy tangible assets because they’d be more expensive in the future. Wrong. Buffett said to buy INTANGIBLES because they require less capital to grow when the economy turns around, and result in higher returns on invested capital. That’s why he used to like stuff like Coke, and branded stuff. Only recently did he start liking capital intensive stuff like railroads and utilities. You could take that as a deflationary hint? Or you could take it for what he says, which is he’s got to park his money somewhere and he expects lower returns.
Lastly, I just read benjamin Franklin’s autobiography… a centuries old book. The debate over printing money was alive and well even back then. It sounded just like it sounds now. Of course, Ben, being a printer, was all for it! Back in the peak of the crisis, Charlie Rose asked Buffett what the fed will do if the TARP, Bailout, zero% interest rates, etc. don’t work,…what’s next? Buffett’s answer was “turn on the spigots!”