Treasury inflation protected securities, better known as TIPS, are bonds issued by the U.S. Treasury Department and are backed by the full faith and credit of the U.S. federal government. Or to be somewhat more blunt, TIPS are backed by the unqualified ability of the U.S. Treasury (potentially in conjunction with the U.S. Federal Reserve) to print whatever amount of money might be required to pay them off at maturity or to make their semi-annual interest payments. TIPS are interesting because they are protected from the ravages of inflation. Here is how they work. The coupon rate is fixed and unvarying. However, the maturity value is adjusted for changes in the CPI (consumer price index). Moreover, because the semi-annual interest payments are based on that maturity value (even though the coupon rate remains fixed), the dollar size of the interest payments also adjusts for the CPI. Thus a TIPS holder is protected from future changes in the level of consumer prices. There remain a few other nuances concerning the provisions of these bonds, but they are incidental to this discussion.
Basis For Popularity
TIPS are unusually popular today with both retail and institutional investors. This enthusiastic popularity is being driven by a fear of inflation. The source of this fear grew out of the actions of the U.S. Federal Reserve, executed over the last five years. When examined in a historical context, the Federal Reserve has implemented policies (since January 1998) that were revolutionary in their scope; these actions made history and have taken us deeply into uncharted waters. Not unreasonably, investors have responded with fear and uncertainty. Let’s recap the Fed’s actions:
• Total U.S. Federal Reserve bank credit grew from $900 billion in September 2008 to $2,900 billion in December 2012.
• Securities held outright by the Fed grew from $500 billion in February 2009 to $2,700 billion in December 2012.
• Mortgage Backed Securities (mortgage bonds) bought and held by the Fed grew from zero back in January 2009 to $900 billion in December 2012.
• The U.S. money supply has grown at unprecedented levels (i.e., the Fed has been “printing money”):
° M2 money supply growth peaked at 11 percent on a year-over-year basis in December 2011,
° M1 money supply growth peaked at 21 percent on a year-over-year basis in mid 2011, and
° MZM (Money Zero Maturity) money supply growth peaked at 17 percent year-over-year back in early 2008.
• The global money supply growth peaked at 22 percent on a year-over-year basis back in mid 2008.
Recognize that these data are truly exceptional and as stated above, take us deep into unknown waters. In normal times, one would rightly expect such “running of the printing presses” to result in a truly fearful resurgence of inflation. But most investors are not adequately appreciating that these are not normal times -- far from it. We continue to experience both national- and global-deleveraging. And no single force better and more completely mitigates the return of inflation than deleveraging. Let’s examine the data in greater detail.
Inflation Won’t Be Coming Back
Inflation won’t be coming back to the U.S. -- at least not for the foreseeable future. Based on the data available today, inflation will remain fully dormant for the next 24 months. But of course, new and different data will arrive tomorrow, and at that point, an understanding and appreciation for the next 24 months could change. Nevertheless, based on today’s facts, inflation remains a nonexistent threat for the next two years. Here are the economic data as of today:
• Deleveraging continues apace and is expected to continue for many more years to come -- both nationally and internationally:
° Total domestic financial debt as a percentage of GDP has fallen 6.66 percent year-over-year through 9/30/12 and
° Total credit market debt of all types and for all sectors as a percentage of GDP has fallen 1.92 percent year-over-year through 9/30/12.
• Import prices (the prices of all the goods and services that we import into the U.S.) have fallen 1.6 percent year-over-year through 11/30/12.
• Nonfarm unit labor costs have risen only 0.1 percent year-over-year through 10/31/2012.
• The productive capacity of the U.S. economy remains heavily unused or underutilized, thus preventing price increases:
° The national capacity utilization rate is running at only 78.4 percent of total capacity as of 11/30/12 and
° Real industrial capacity (how much we could produce if we turned on all the factories) increased by 1.5 percent year-over-year through 11/30/12.
• The inflation pipeline already has falling prices baked into the manufacturing and distribution processes, i.e.:
° The producer price index of crude goods has fallen 1.8 percent year-over-year through 11/30/12 and
° The producer price index of intermediate goods has fallen 0.3 percent year-over-year through 11/30/12.
• Consumer price inflation as measured by the CPI remains dormant at only 1.8 percent year-over-year through 11/30/12.
• There remains an overabundance of unused or underused workers in the U.S.: The number of American’s with jobs as a percentage of the total population has fallen to 58.8 percent from a high of 64.7 percent reached back in February 2000 and the unemployment rate stands at 7.75 percent as of 11/30/12.
• The unemployment rate overseas places a hard ceiling on any future increases in employment costs here in the U.S. The unemployment rate in Europe (ex UK) was 11.7 percent as of 11/30/12.
• The U.S. Dollar has been appreciating, making it cheaper for us to import goods, thus avoiding domestic price increases. The trade-weighted U.S. dollar has risen 1.92 percent on a year-over-year basis through 11/30/12.
• Finally, demographic trends inside the U.S. are working strongly against any resurgence of inflation. Consider two different cohorts of Americans, those aged 20-24 and those aged 60-64. Today, the number of 20-24 year-olds minus the number of 60-64 year-olds is 4.7 million. But by 2021, this number will fall to 0.6 million. The affect of this change will place extreme downward pressure on inflation. The reason is simple. Americans aged 20-24 tend to be low-productivity and spend over 100 percent of their respective incomes. In contrast, those aged 60-64 tend to be some of the most productive workers and they are at their peak savings years. Thus, changes in the demographics of the American workforce between 2012 and 2021 will significantly enhance productivity and will decrease consumption -- both trends are deflationary.
• Moreover, no matter how fast the Federal Reserve prints new money, it is more than offset by an even more rapid collapse in the velocity of money. The year-over-year change in the velocity of money based on three-year smoothing has fallen 8.8 percent as of 11/30/12.
TIPS Are Grossly Overpriced
The unfounded fear of inflation has resulted in a relative stampede towards TIPS, driving their prices to ridiculously high levels. Recall that TIPS do not guarantee a profit, they only guarantee that their maturity value (and therefore their semi-annual interest payments) will adjust for inflation. It is just as easy for TIPS to become grossly overpriced as any old tech stock. As of the close of markets on 12/31/12, TIPS bonds were priced to yield the following:
• -1.37 percent for a 5-year maturity
• -1.09 percent for a 7 year maturity
• -0.67 percent for a 10-year maturity
• +0.15 percent for a 20-year maturity
These are all real yields after the CPI.
If we assume that the duration of a 20-year maturity TIPS is 11, then we could estimate that for an increase of just 2 percent in the real interest rate, the price of a 20-year TIPS bond would fall by 22 percent (e.g., -22 percent = -11 x 2 percent). So let’s consider the ratio of reward to risk for this bond. The 20-year TIPS is currently paying 0.15 percent per year (real return) on the reward side of the ledger. But on the risk side, if real interest rates go up by 2 percent tomorrow, then my TIPS bond will fall in price by 22 percent. If your financial advisor has you invested in TIPS bonds, you might want to ask him what his logic is.
A Better Trade
A far better trade is to short TIPS bonds by buying the ETFProShares UltraShort TIPs (TPS). If one felt that they preferred a somewhat more balanced trade, they could short TIPS using symbol TPS and then go long high-yield bonds (under the presumption that we would avoid the two extremes, i.e., a severe recession and a measurable uptick in inflation) using the iShares iBoxx $ High Yield Corporate Bond ETF (HYG). If the investor preferred to be “technically” dollar-neutral they could replace symbol HYG with ProShares Ultra High Yield ETF (UJB). I prefer the simple arbitrage between TIPS and high yield by buying equal portions of TPS and HYG. In any event, until such time as the economic data experiences a remarkably profound change, the short TIPS trade should be prudent and practical.
Rob Brown, PhD, CFA, is chief financial strategist for Eqis Capital Management Inc. in San Rafael, Calif. You can reach him at [email protected]. All economic and capital market data was provided by Ned Davis Research of Atlanta, Ga., and was the most recent data available as of January 2.