Why TIPS might be a smart place to park cash right now
Inflation is 8% or more, depending on how you count it (and who counts). The Federal Reserve is clearly panicking. And the markets are clearly panicking too.
So at this point Uncle Sam would like to offer you a bet.
Would you like to bet your hard-earned retirement savings that inflation is going to crash in a very short time, and crash so far, so fast that over the next five years the medium will be less than 2.4%?
Lily: Market overview
Oh, and to make the bet even more interesting, here are some additional conditions: if you win the bet and average inflation is below 2.4% by 2027, you will make a very small profit, but if you lose the bet you could lose, and lose big.
How does it sound?
If this sounds crazy to you, you’re not alone. Sounds pretty crazy to me too. But here’s the sting in the tail: you may already be making this bet, without even knowing it. In fact, the more cautious and risk averse you are, the more likely you are to take this bet.
I’m talking about investments in US Treasury bonds.
With double-digit inflation, FVX 5-year Treasury bills,
pay 4% interest and 10-year TNX treasury bills,
3.7%. The oldest bond, the 30-year bond, pays 3.6% interest.
These may or may not turn out to be successful bets, depending on what happens next with inflation and the economy. All that needs to be said about predictions has been made by Casey Stengel: “Never make predictions, especially about the future.
But in this particular case, we have an extraordinary puzzle: while ordinary Treasury bonds offer the interest rates just mentioned, a parallel set of Treasury bonds offers another set of interest rates with locked-in guarantees against persistent inflation. And the prices look… well, weird.
So-called TIPS bonds, which stand for TIPs of Treasury Inflation Protected Securities,
are a niche product issued by the US Treasury and come with the same guarantee against default as regular US Treasury bonds, but with prices and interest payments that automatically adjust for inflation. (The mechanism is so complex that any attempt to describe the inner workings would confuse more than it enlightens. Suffice it to say that if you buy a TIPS bond and hold it to maturity, you will get the rate inflation rate each year plus or minus a specified “real return”, depending on the price you pay when you buy it).
Currently, if you buy 5-year TIPS bonds, you can lock in an interest rate of around 1.6% per annum plus inflation. If inflation averages 0% over the next 5 years, you will earn 1.6% per year. If inflation averages 10%, you will earn about 11.6%. Etc. You get the picture.
The story is similar the longer the TIPS bond you buy. If you buy a 10-year TIPS bond, you’ll earn about inflation plus 1.4% per year, and if you buy a 30-year TIPS bond, you’ll earn about the same.
Maybe TIPS bonds will prove to be a great bet over the next 5 or 10 years or more. Maybe not. But, mathematically, the only way they can prove they’re a worse betting that ordinary treasuries is if inflation is really, really low. And I mean medium inflation, from now on.
Hence the “bet” with which I started this article.
Five-year TIPS bonds will be a better bet than 5-year Treasuries only if inflation averages below 2.4% over the next 5 years. Ditto for 10-year TIPS bonds and 10-year Treasury bills. For that to happen, inflation doesn’t just have to come down. It must collapse, and quite quickly too.
And, even worse, anyone who buys regular Treasuries instead of TIPS is taking asymmetric risk. Buy a 5-year Treasury bond yielding 4%, and if inflation crashes in the short term, you could, in theory, end up earning maybe 1% a year more than you would on the bond TIPS. But if inflation stays high, or even (heaven forbid) gets worse, the person who buys the regular treasury bill is watered down. You’ll lock in 4% per year for 5 years while consumer prices go up by, say, 8% or whatever.
There are simple mechanisms that partly explain this bizarre situation. Large institutions, passive investors, and financial advisers worried about their own liability instinctively buy ordinary treasury bills rather than TIPS: they are considered the default and “risk-free” asset for the sole reason that they have always been, and are the biggest and most important. liquid securities in the world. It’s hard to get sued for putting your customers in cash.
The total ordinary treasury bill market is more than 4 times the size of the TIPS market, and the daily trading volumes are huge.
Moreover, TIPS obligations have never been necessary before. The British government invented the concept in the early 1980s, after the inflationary disaster of the 1970s, and our own Uncle Sam not until the late 1990s. Until now, TIPS bonds have only existed for a long period of deflation, when they proved to be acceptable but not as good as ordinary fixed rate Treasury bills. During recent deflation-era panics, such as the crash of 2008-9 and the Covid crash of 2020, TIPS bonds fell.
It is probably difficult to sell fire insurance to people who have never experienced a fire and have never seen one, especially if the fire insurance itself is a new product that has only been created long after the last big fire, so he never paid. Same as inflation insurance.
Late last week, I asked Steve Russell about it. Russell is Chief Investment Officer at Ruffer & Co., a London-based fund management firm that successfully avoided the market crashes of 2000-3 and 2007-9. (Ruffer has been worried about inflation for more than a decade and is heavily invested in inflation-protected bonds: do what you want with them.)
Calling TIPS “incomprehensible” returns, Russell says he suspects “market myopia and attachment to past orthodoxies.” As he puts it, bond market inflation expectations have remained broadly flat all year “as if the current inflation never happened.” Bond investors are confident the Fed can and will do “whatever it takes” to bring inflation back to the old 2% target, and will do so relatively quickly.
Russell doesn’t believe that’s going to happen. He thinks the Fed will find the economic cost of the rate hike too high. He also thinks the world is now much more inflationary than it used to be, due to a variety of factors, including Ukraine, outsourcing manufacturing and rising labor power.
(Interestingly, while here in Britain, I’ve noticed that multi-year cellular contracts here now include an inflation rider, with rates increasing with inflation plus a few percent each year. Covid lockdowns, cellular contracts were generally defined by deflation, not inflation.)
TIPS bonds have performed very well so far this year, even as inflation has surged. This is precisely because the market still expects an imminent collapse in inflation. Moreover, TIPS bonds started the year overvalued: they were so expensive that many of them actually guaranteed a “negative real return”, i.e. a little less inflation, until at the due date.
Bonds are like seesaws: when the price goes down, the yield or interest rate goes up. The fall in TIPS prices this year has resulted in much larger, and now positive, real returns.
One caveat is that TIPS prices could continue to fall, leading to even higher real yields. These inflation-adjusted returns were north of 2% and sometimes even higher. So if you consider TIPS to be good business now, there’s nothing stopping them from getting even better in the future.
Those who invest in TIPS through a mutual fund will have to accept this volatility as part of the deal. TIPS could fall further if recent market trends continue. On the other hand, if you buy individual TIPS bonds (available from any broker) and hold them until maturity, volatility won’t matter that much. You will get the “real” inflation-adjusted guaranteed return for the full term of the bond.
A curious feature of US TIPS bonds (but not foreign alternatives) is that they are always guaranteed to be redeemed at face or face value when they come due, even if there has been massive deflation. So it generally makes sense to buy individual bonds close to face value if you can.
Incidentally, due to tax complications, it is generally best, whenever possible, to own TIPS in a protected account such as an IRA (Roth or traditional) or 401(k).
Mindful of Stengel’s saying, I don’t make predictions. But I bought TIPS bonds in my own IRA and 401(k), not because I want to forecast inflation, but because I don’t want to forecast inflation. I see no reason to make risky, asymmetrical bets on an impending inflation crash through regular treasury bills when I can get a low but guaranteed interest rate on top of inflation no matter what. ‘she is.