A Few TIPS on Inflation Protection

What a whacky, whacky world…

“Debt sales highlight abnormal conditions,” says the headline in yesterday’s Financial Times.

Abnormal? Freaky. Bizarre. Strange.

The latest auction of TIPS – US Treasury debt with inflation protection – produced a curiosity. Investors were willing to pay $105 for every $100 worth of inflation-protected notes.

Go figure.

What does it mean? What are investors worried about? On the surface of it, they are setting themselves up for a built-in loss. TIPS always offer less interest than regular bonds. You give up some yield to pay for the inflation protection. But TIPS buyers are now buying them with negative yields. Which is to say, they pay for the privilege of owning the bonds. Inflation has to beat expectations…and then some…before they are even at breakeven.

All very weird. If they are so afraid of inflation, why not buy gold? No negative yield. You pay $100…you get $100 worth of gold.

And you won’t have to worry about the people who are making the calculations. In the case of TIPS, the people who sell the notes are the same people who determine how much they’re worth – because they’re the people who figure out the CPI. Besides, we haven’t studied the matter, but when we last looked into it, we found that there was a delay in making the adjustments. So, in a period of hyperinflation the adjustment process would be overrun by events. When Hungary had its hyperinflation of 1947, for example, the pengo lost half its value every 13 hours. No adjustment in the world can keep up with that rate of loss… A TIPS holder would be wiped out. A gold buyer, on the other hand, would be, well, golden….

The other strange thing about protecting oneself from inflation via TIPS is that there isn’t any inflation to speak of. According to the people who keep the statistics, the rate of consumer price inflation is barely 1%. And according to the people who buy regular non-adjusted Treasury debt, there is no inflation on the horizon either.

All of which makes the TIPS auction curiouser and curiouser…

Stock market investors didn’t seem to know what to make of it either. The Dow ended yesterday essentially unchanged.

Gold didn’t know what to think. It didn’t move yesterday.

And that’s not all…how’s this for weird?

From Bloomberg:

“Dollar Gains Against Euro on Speculation Fed Easing Will Spark Inflation”

Huh? Investors worried about inflation in the dollar. They buy dollars? Yep.

The dollar strengthened against the euro for the first time in three days on speculation an increase in debt purchases by the Federal Reserve will cause inflation to accelerate.

Sterling rallied against all of its major counterparts as a report showed the UK’s economy grew in the third quarter at double the pace forecast by economists and Standard & Poor’s raised the nation’s credit outlook. The yen dropped versus the dollar on the prospects of Japan renewing intervention to weaken the currency and protect exporters.

“Inflation expectations have been lifted because people think the Federal Reserve will be successful,” said Marc Chandler, global head of currency strategy at Brown Brothers Harriman & Co. in New York.

The US currency appreciated 0.8 percent to $1.3859 per euro at 5 p.m. in New York, from $1.3965 yesterday. The dollar gained 0.8 percent to 81.43 yen, from 80.81 yesterday, when it reached 80.41 yen, the lowest level since April 1995. The euro was little changed at 112.86 yen, compared with 112.85.

The Dollar Index, which IntercontinentalExchange Inc. uses to track the greenback against the currencies of six major US trading partners including the euro, yen and pound, increased 0.7 percent to 77.6533. The gauge has fallen 1.4 percent in October on speculation a boost in debt purchases, also known as quantitative easing, will erode the value of the greenback. The Fed is next due to decide on policy at its Nov. 2-3 meeting.

The markets are seriously confused. Inflation? Deflation?

Well, what are we going to do?

We’ll hold our gold. We’ll sit. We’ll laugh. And we’ll wait for this whole shebang to go ka-plouey.

How’s that?

Bill Bonner
for The Daily Reckoning

The Daily Reckoning