Thursday, April 9, 2009

TIPS Are Gaining

Today's stock rally and the price of oil has pushed inflation expectations higher -- although only mildly -- but if these trends continue, Treasury inflation-protected securities (TIPS) are likely to catch a bid. Today, 10-year TIPS are priced for the consumer price index to increase at a 1.35% rate, up 2 basis points from yesterday but 13 basis points below the March 26 peak of 1.48%, which was the highest since Oct. 1, 2008.

A number of factors have pushed inflation expectations higher of late. One of these is the recent surge in equity prices, which by itself is a positive for the economic climate and a factor that reduces the deflationary impetus. A second factor boosting inflation expectations is the renewed expansion of the Federal Reserve's balance sheet, which has expanded by about 10% over the recent weeks, to $2.05 trillion. A further expansion is likely in the time ahead, because of the Fed's asset-purchase program (the purchase of Treasury, agency and mortgage-backed securities). New data on this front will be released late today.

An interesting angle on the movement in TIPS relative to conventional Treasuries is that the Fed is concentrating its purchases on conventional Treasuries, which increases the value of conventional Treasuries relative to TIPS. This should narrow the yield spread, but has not. This shows that other factors are helping TIPS to outperform -- chiefly the rise in inflation expectations.

The equity market is unlikely to be alarmed by any initial rise in inflation expectations, in part because the equity market itself is likely to fuel the rise, which makes for a circular argument. Moreover, with unemployment possibly headed to 10% (although I don't think it'll reach that high - maybe 9.25%...), few are likely to believe that inflation will be making a comeback anytime soon.

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