As reported in this Bloomberg News story, the five-year TIPS (the Treasury Inflation-Protected Security due in 2012) yield has been negative since Feb. 29, and traded today at minus 0.17 percent. The notes, which were first sold in 1997, have never before traded at a yield below zero.
That much is fact. What is not fact, however, is Bloomberg’s interpretation.
Bond investors have never been so sure that the Federal Reserve will lose control of inflation. They’re so convinced that they’re giving up yields just to buy debt securities that protect against rising consumer prices.
Because TIPS pay a principal amount that rises in tandem with the consumer price index, buyers accept lower yields in a bet the inflation adjustment will make up the difference. TIPS have returned 6.2 percent this year, compared with 3.7 percent from regular Treasuries.
But the TIPS yield does not measure inflation expectations. The nominal yield comes closer to doing that. Five-year nominal yields have dropped 1.03 percentage points this year to 2.41 percent. Some of that drop, of course, is driven by flight to quality. But it is the nominal yield, not the inflation-adjusted, or real, yield that measures inflation expectations. Judging from current low levels of nominal interest rates the bond market does not expect sustained inflation–especially of the tangible things, like real estate assets, that you can hold instead of bonds. Both represent a way to transfer purchasing power from this year to some year in the future. Arbitrage keeps them pretty close together.
Then what does the TIPS yield measure? TIPS are pieces of paper that pay the investor 2 kinds of yield. They pay interest–the TIPS yield. And investors receive a second payment at maturity based on the performance of the CPI over the investment period. In other words, TIPS are bonds with an option attached. It is the value of that option that drives the TIPS spread.
In principal, the Treasury could bonds with other kinds of options attached too. They could base the option on any event: increase the principal by GDP growth; pay the investor a kicker if the Red Sox win the Series; or inflate the principal by the square root of the Fed chairman’s hat size. The option is simply a bet that is written into the security.
The TIPS option increases the principal payment by the cumulative increase in the CPI over the life of the instrument. But the CPI is more than half made of of services, like haircuts and guitar lessons. Since nobody has yet figured out how to store a guitar lesson, they are very poor vehicles for transferring wealth from this year to a future year. You need something that decomposes slowly to do that, like a house or a piece of gold. For this reason, there is no reason to expect the CPI inflation rate to bear a close relation to interest rates. There is no way to arbitrage their yields together.
A lot of the recent increases in prices (think oil, steel, copper, lead, Rembrandts,…) are actually relative price increases caused by screaming global growth. If everyone in the world gets rich they all want to buy the same stuff. That makes certain kinds of things–the ones whose supplies can’t increase–go up a lot. That’s nature’s way of telling the people that were using them before–us–to back off. Of course it also makes more goods and services in the world get produced, which drives some prices down. But it doesn’t have to be the same prices.
It’s clear to me that global growth is being driven by the extraordinary productivity gains in China, India and other countries where workers are getting their first whack at competing for the world’s capital. That’s a tremendous increase in labor services using roughly the same stock of physical capital and the same supplies of oil and copper. So it shouldn’t surprise us that the relative prices of capital and fixed-supply commodities are going up and the relative supplies of labor services are going down.
Sustained inflation of real assets–the kind that shows up in nominal interest rates like the late 1970’s–happens when central banks produce sustained increases in the monetary base and bank reserves. (That has not happened. The US monetary base has increased by 1.1% in the last 12 months. Bank reserves have increased by 1.6%.) Not when there is a relative price increase–no matter how big. Bond yields are going to stay low for a long time even if CPI inflation is substantial. That is what is driving the negative TIPS yield.
JR
