TIPS are telling us that the market is quite pessimistic about the prospects for real growth, but not concerned at all about the outlook for inflation.
The above are edited excerpts from an article* by Scott Grannis (scottgrannis.blogspot.ca/) entitled Gold and Real Yields Have Tracked Each Other Post-Crisis.
The following article is presented by Lorimer Wilson, editor of www.munKNEE.com (Your Key to Making Money!), www.FinancialArticleSummariesToday.com (A site for sore eyes and inquisitive minds) and the FREE Market Intelligence Report newsletter (register here; sample here) and has been edited, abridged and/or reformatted (some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. This paragraph must be included in any article re-posting to avoid copyright infringement.
Grannis goes on to say in further edited excerpts:
The introduction of TIPS (Treasury Inflation Protected Securities) in 1997 …gave us the ability to see real interest rates in real time [as opposed to having] to infer real yields after the fact.
Real yields are a significant contribution to analysts’ arsenal of data, since they can be used to discover what the market is expecting about the future of economic growth and inflation.
- Currently, TIPS are telling us that the market is quite pessimistic about the prospects for real growth, but not concerned at all about the outlook for inflation.
Before, when nominal yields rose we didn’t know how much of that was due to rising inflation expectations or rising real growth expectations. Now,
- if real and nominal yields rise by the same amount, then we know it’s because the market’s real growth expectations are rising and
- if nominal yields rise more than real yields, then we know it’s because inflation expectations are rising.
Nominal vs. Real Yields
The chart below compares the nominal yield on 5-yr Treasuries to the real yield on 5-yr TIPS. If you subtract the real yield on TIPS from the nominal yield on Treasuries you get the market’s expected inflation rate over the next 5 years (more commonly referred in the bond market as the “break-even” inflation rate, since that is the inflation rate that would cause holders of TIPS and Treasuries of similar maturities to have similar total returns).
The main message of the above chart is that:
- inflation expectations haven’t changed much over the past 17 years: the average expected inflation rate since 1997 is 1.94%, and the current expected inflation rate, by this measure, is 1.98% and
- the market is not very concerned about rising or falling inflation, and that, in turn, suggests that the Fed is doing a good job.
Real Yields vs. Real GDP Growth
In theory, real yields on financial instruments should tend to track real economic growth, because you need economic growth to deliver positive real returns to investors. Not surprisingly, we can observe this thanks to TIPS. Real yields on TIPS have tended to track the real growth rate of the economy, as the chart below shows, where I’ve used 5-yr real yields on TIPS as a proxy for the market’s expectation for future growth, and I’ve used a 2-yr annualized measure of real GDP growth as a proxy for the current level of growth.
When real economic growth was in the 4-5% range in the late 1990s, TIPS’ real yields were 3-4%. Since then, economic growth has been trending lower, and so have the real yields on TIPS. The current level of real TIPS yields, according to the above chart, suggests that the market is priced to the expectation that real growth in coming years will be 1% at best. That’s pretty pessimistic.
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Gold vs. Real Yields
Real yields on short- and intermediate-maturity TIPS can also serve as proxies for the market’s desire for safe assets. TIPS are unique in that they are default-free, inflation-protected, and they are the only security in the world with a government-guaranteed real yield that you know in advance. Gold is a classic “safe asset,” being historically a refuge from inflation and geopolitical risk. As the chart below shows, the price of TIPS (shown here using the inverse of their real yield as a proxy for their price) has tracked the price of gold in recent years quite closely since 2007. Both have acted as safe havens for all the concerns that arose in the wake of the 2008 financial and economic collapse that affected nearly everyone around the globe.
One of the more important developments of the past year or so is the decline in both TIPS and gold prices. That tells us that the world’s demand for safe assets has declined meaningfully, even though it remains elevated.
I’ve been watching these two assets very closely for over a year, looking for signs of a further decline in the demand for safe assets. Should it occur, I think that would go hand in hand with a return of optimism, a decline in the demand for money, and, eventually, an acceleration in nominal GDP and inflation. That, in turn, would show up as higher interest rates and probably a somewhat stronger economy.
Editor’s Note: The author’s views and conclusions in the above article are unaltered and no personal comments have been included to maintain the integrity of the original post. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor.
*http://scottgrannis.blogspot.ca/ (Copyright © Calafia Beach Pundit)
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