The Importance of Treasury Inflation Protected Securities (TIPS)

Inflation Rate

inflation-meter-2-ssIn several of the posts I have written for LearnBonds in the past I have discussed the importance of Treasury Inflation Protected Securities or TIPS in trying to interpret the what the bond markets are trying to tell us.  I have focused primarily on the 10-year TIPS because it is a longer-term maturity and is closely watched by many people that closely follow the financial markets.

Because the yield on this security is adjusted regularly for actual inflation, the yield is felt to represent a “real” yield and is often claimed to be a proxy for the real rate of interest.  Being associated with the real rate of interest is important because economist argue that there will be some relationship between the real rate of interest and the real rate of economic growth. Now I want to discuss where the yield on the 10-year TIPS currently is, but I need to go back a little and set the scene for where we are today. Earlier when the Federal Reserve put a series on the yield of the 10-year TIPS together, early in 2003 up until the beginning of the Great Recession in December 2007, this yield varied roughly between 2.0 percent and 2.5 percent.  This range seemed to be about 50 basis points below what was then seen as the expected real rate of economic growth of the United States economy.  Thus, the yield on these TIPS seemed to represent a real rate of interest that was roughly consistent with market expectations of the real rate of growth of the US economy. Then the Great Recession hit.  I don’t want to spend anytime on the Great Recession so lets move on to early in the year 2010.  As can be seen from the accompanying chart, in January 2010, the yield on the 10-year security was around 1.5 percent, a little lower than before the Great Recession hit. (Note that the yields charted are weekly averages to smooth out some of the daily swings.)  We can explain the fact that this is a little lower than before because expectations of real economic growth coming out of the recession were lower. mason1 Now, look what happened to this yield after the early part of 2011.  The yield dropped precipitously and turned negative for an extended period of time.  This time period coincided with the movement of vast sums of money from European financial markets that occurred during the financial upheaval that took place at this time.  Risk-averse money left the continent and moved into the “safe haven” of United States Treasury issues. The yield began to rise and returned to a positive yield at the time financial markets in Europe began to heal.  This was a vivid example of how the international movement of risk-averse money can distort interest returns in “safe haven” countries. In the week ending June 14, 2013 the yield on the 10-year TIPS broke back into positive territory.  As you can see the yield moved into the range of 50 basis points to 70 basis points with the daily yield reaching above 90 basis points for a few days. As the money left the American markets, the real yield rate to return more to a yield that reflected the expected growth rate of the economy.  Expectations of economic growth were lower than before the Great Recession, but the financial markets seemed to believe that the economy was going to move a little faster than it had been moving. Now, let’s look at the situation over the past 12 month period. mason2 The interesting thing about the timing of this decline is that it came around the time when the Federal Government, the Federal Reserve System, the International Monetary Fund, and others, began to reduce their projections of economic growth for the United States.  And, these agencies continue to talk about the fact that the growth rate of the United States is just not expected to pick up in the near term. Funny coincidence! Since the real rate of interest, as I have discussed before, serves as the foundation for the level of nominal interest rates in the economy, it is not surprising to observe that the yield on the regular 10-yield Treasury bond fell but almost exactly the same amount as did the yield on the 10-year TIPS. The bottom line to this discussion is that late last year and earlier this year, many analysts, myself included, voiced our opinion that the interest rate on the 10-year Treasury would rise and would even get up over 3.00 percent.  (It closed around 2.55 percent on Wednesday afternoon.)  Little did we expect at the time we were making the prediction about the future level of the 10-year Treasury that the market would be reducing its expectations of future economic growth.  We didn’t expect the reduction because the economy seemed to be showing signs that it was becoming a little more robust. Well, if it were easy to forecast interest rate movements we would all be a lot wealthier. About

John Mason John MasonJohn has been the President and CEO of two publicly traded financial institutions and an Executive Vice President and CFO of a third. He has also spent time as an economist in the Federal Reserve System and worked for a cabinet secretary in Washington, D. C. In addition John taught in the Finance Department at the Wharton School of the University of Pennsylvania for ten years. He now currently has a column on the blog Seeking Alpha and is ranked number 3 in terms of readers on the economy. From this column, two books have been published this past year from earlier blog posts. John is active in the shadow banking world, the venture capital space, and in angel investing. Other than that John works with start ups and early stage organizations, for profit and not-for-profit.

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