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TIPS valuation update

TIPS continue to rise in price (which is shown in this chart as a decline in their real yield to maturity), as demand for their inflation protection increases. This has been the salient feature of the bond market since the beginning of last month: real yields have declined across the board, and they have declined relative to nominal yields of comparable maturity.

This rise in inflation concerns is a somewhat belated response to the revival in inflation itself, as this second chart shows. The year over year decline in the CPI which started late last year, and has dominated the headlines, has masked the 2.7% annualized rise in the index for the year to date, and the 3.5% annualized rise over the past six months. Inflation is alive and well, despite the enormous amount of "slack" in the economy that, according to the Fed's inflation model, should be producing active deflation by now.

The inflation implied by the difference between real yields on TIPS and the nominal yield on Treasuries has risen significantly from its low of late last year (when the market expected CPI inflation to average almost zero over the next 10 years), to now 2.2% over the next 10 years. The 5-year, 5-year forward inflation expectation has risen from 0.7% to 2.7% over the course of this year. By either of these measures, however, TIPS are still priced to future inflation being equal to or less than what it has been so far this year, and well within the range of where it has been in the past 5 or 10 years. In other words, the bond market has not yet begun to price in any increase in inflation beyond the ordinary, despite the enormous expansion of the Fed's balance sheet in the past year, and the Fed's repeated assurances that they will keep short-term interest rates very low for a very long time.

So, while the first chart suggests that TIPS on a standalone basis are relatively expensive at current levels of real yields, they are a risk/reward bargain compared to Treasuries.

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