To begin with, the real yield on TIPS today is very close to an all-time low. In fact, real yields on TIPS are negative all the way out to 15 years' maturity. The chart above shows the real yield on 10-yr TIPS, and I have overlaid my view of how attractive or unattractive real yields happen to be. With real yields as low as they are today, investors in most TIPS are guaranteed by the US government to lose some portion of their purchasing power every year. Looked at another way, with yields super-low, prices are super-high, and that implies very strong demand for TIPS. And very strong demand for something means that it is not very attractive from an investor's point of view.
This chart compares the real yield on 10-yr TIPS to the nominal yield on 10-yr Treasuries. The difference between the two is the market's "break-even" or implied annual inflation rate over the next 10 years. Here we see that both TIPS and Treasuries enjoy exceptionally strong demand, because their yields are both very close to all-time lows. However, the market's expected rate of inflation is about average: 2.3% for the next 10 years, which is only slightly less than the 2.4% annualized CPI over the past 10 years. From this we can deduce that although TIPS are very expensive—trading very close to all-time high prices—it's not because investors fear inflation. Inflation expectations today are quite normal.
With this next chart I try to show how the real yield on 5-yr TIPS tends to track the economy's real growth rate over time. In the late 1990s, economic growth rates were very strong, and TIPS yields were extraordinarily high. That made perfect sense, because the real yield on TIPS had to be competitive with the real return on other securities, and other securities were delivering fabulous real returns because the economy was so strong. Today it's just the opposite. Real yields are low because the market expects economic growth to be very weak; as this chart suggests, the real growth expectations driving 5-yr TIPS are likely somewhere in the neighborhood of 0-1% on average over the next 5 years. There is so much fear about the future out there in the market that investors are happy to lock in a guaranteed loss of purchasing power with TIPS because they believe that the return on alternative investments will be much worse, and that is what one would expect if the economy were indeed to grow less than 1% per year over the next five years.
This next chart shows my calculation of the 5-yr, 5-yr forward expected inflation rate embedded in TIPS and Treasury prices (Bloomberg's calculation of this rate today is 2.74%, mine is 2.67%). Think of this as what the market's 5-yr inflation expectations will be, five years from now. Since the 10-yr expected rate is 2.3% and the expectation for the second half of the next 10 years is 2.7%, that means the market expects inflation to average just under 2.0% over next five years.
Contrast the situation today (super-low real and nominal yields) with conditions at the end of 2008 (low nominal yields, relatively high real yields). Back then, the market feared deflation more than anything else (the 5-yr, 5-yr forward expected inflation rate was less than 0.5%), and demand for TIPS was very weak. But today, the market fears very weak growth more than anything else, which is why both TIPS and Treasury yields are extremely low. On the margin, the market has been worrying more and more, over most of the past year, that inflation could creep up at some point in the future, even as the market has been worrying that the economy will be weaker.
To be in a situation where market expectations call for very weak growth for as far as the eye can see, while at the same time expecting somewhat higher inflation is remarkable, because it refutes the traditional Phillips Curve mentality that says inflation goes up only when the economy is very strong, and goes down when it is very weak. This is one more blow to Keynesian-type thinking, and I say good riddance.
In my view, the bond market is correctly evaluating the implications of today's very accommodative monetary policy coupled with today's very oppressive fiscal policy, and concluding that on the present track, we are heading towards a very weak economy with somewhat higher inflation.
Just because the deficit is still huge as a percent of GDP does not mean fiscal policy is expansionary. On the contrary, as Milton Friedman always taught us, it is the level of government spending more than anything else that is the important fiscal variable to watch. Whether a given level of spending is financed by borrowing or by taxes is not as important as whether the government is commandeering too much of the economy's resources. With federal spending currently running about 23.5% of GDP (12% higher than the 40-year average of 20.9%), I think spending (the bulk of which is transfer payments from the most productive members of society to the less productive) is too high and it is acting as a headwind to the economy's ability to grow. The government is wasting a significant portion of the economy's resources that could be better utilized by the private sector, in addition to creating perverse incentives.
All of the above adds up to one more reason why I continue to insist that the market is priced to very pessimistic assumptions, e.g., the Fed is going to make an inflationary mistake and there is very little chance that our bloated federal government will become less oppressive. If you agree with the market, then you stay in cash on the sidelines, and/or you buy TIPS and Treasuries in case things turn out to be even worse. If you think there is a chance that things could improve even just a little bit, then you avoid cash, Treasuries, and TIPS, and you invest in just about anything else: stocks, corporate bonds, and real estate. I exclude gold and commodities from this list, because I think they are priced to a very big inflationary mistake on the part of the Fed. If the Fed manages to keep inflation below 3-4% for the foreseeable future, then I would expect to see gold prices decline significantly, and that would imply very little, if any, upside potential for commodities.
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