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The message of TIPS: extremely weak growth ahead

If you had been stranded on a desert island for the past 10 years and the first thing you saw upon returning to civilization was the chart above, you would most likely figure that dollar inflation must be very high. Why? Because with the real yield on TIPS at its lowest level ever, and firmly in negative territory, you would know that the price of TIPS was at a record high level; and from there it would follow that if investors were willing to pay an unprecedented price for TIPS, then the inflation protection afforded by TIPS must be in very high demand, and therefore inflation must be very high and/or threatening to be very high.

But you would be wrong.

As these two charts show, the expected rate of inflation that is priced into TIPS and Treasuries is relatively low and very normal. The top chart shows the break-even expected rate of inflation over the next 10 years, and it is the difference between the nominal yield on 10-yr Treasuries and the real yield on 10-yr TIPS. The bottom chart shows the 5-yr, 5-yr forward expected rate of inflation, as derived from the pricing of 5- and 10-yr Treasuries and TIPS, and as calculated by Bloomberg. This measure is also the Fed's preferred measure of inflation expectations, and it reflects what investors expect inflation to average over the period 2017 through 2022. The 10-yr expected rate of inflation is now 2.12%, and the forward expected inflation rate is 2.65%. Both compare very favorably to past inflation: the CPI has risen at a compound rate of 2.6% over the past 2 years, 2.0% over the past 5 years, and 2.4% over the past 10 years. Nothing unusual at all about these numbers.

So if the real yield on 10-yr TIPS is at amazingly low levels, but inflation expectations are very normal, what then does the top chart tell us? Actually, it tells us nothing, since to fully understand the message of TIPS pricing you have to also know the price of Treasuries of comparable maturity. That's what the second and third charts in the post show. If TIPS are extremely expensive, but inflation expectations are normal, then the real message is that interest rates in general (both real and nominal) are extremely low. And why are interest rates in general extremely low? The only logical answer is that investors believe that the outlook for the future is very weak growth and average inflation for as far as the eye can see. Very weak growth, as in the weakest growth we've seen on average in my lifetime.

So TIPS aren't really saying anything unusual about the outlook for inflation, but they are saying that the outlook for growth is dismal. Investors are buying TIPS with the full knowledge that they are going to give up purchasing power (as a direct consequence of negative real yields) in the future in exchange for the default-free nature of TIPS (with the exception of TIPS maturing more than 20 years from now, since those real yields are still marginally positive, as seen in the chart above). You buy TIPS today because you figure you would rather lose purchasing for sure, rather than risk losing even more by buying virtually anything else, or even by just holding on to cash or currency.

The message of TIPS is that the market has an extremely pessimistic outlook for the future: pessimism rules. Which of course means that you don't have to be very optimistic about the future to be a bull these days.

UPDATE: I should add that I continue to expect the economy to grow, albeit at a relatively slow pace. Although this would leave the unemployment rate very high, and jobs growth relatively low, I believe my outlook places me well to the optimistic side of the dismal expectations built into current market prices.

Plus, my comment from below bears repeating here: "If the high prices of TIPS reflected huge demand for inflation protection, then Treasury prices would have to be much lower, and the spread between TIPS and Treasury yields would have to be much higher. In other words, we would have to see relatively high inflation expectations if the demand for inflation protection were relatively high. But that's not the case.

Moreover, the extremely low level of all interest rates, coupled with inflation expectations that are simply average, can only be intrepreted to mean that the bond market is effectively expectating economic growth to be extraordinarily weak for as far as the eye can see. Rates are low because the economy is expected to be very weak, and the market rationally expects that very weak growth will force the Fed to keep rates very low for a long time.

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