TIPS On How to Protect Yourself from Inflation

“You would probably suck less as a friend than you do as a boyfriend,” a disgruntled girlfriend once remarked to your California editor. “But then I’m not really sure about that either.”

Your editor laughed, smiled at his girlfriend and replied, “Wow, that’s the sweetest thing anyone has ever said to me!”

This lighthearted conversation unfolded in the context of irreconcilable differences. (He was a sushi-eating Neil Young fan; she was a cheeseburger-obsessed Radiohead fan. There was simply no way to bridge this divide.) Despite their differences however, both parties sought an amicable resolution of some kind – i.e., the infamous “let’s be friends” solution…that never seems to solve anything.

Your editor and his disgruntled girlfriend were simply hoping to maintain some kind of relationship – preferably one that would “suck less” than the romantic one they were attempting. Many fixed-income investors have adopted a similar philosophy during the last few months.

Since long-term corporate bonds have rallied mightily, while the yields on money market funds and short-term Treasurys have collapsed to slightly more than zero, attractive fixed-income opportunities have become very scarce. Simply stated, the bond market sucks. Therefore, fixed-income investors are lowering their expectations and hoping to find securities that “suck less.”

TIPS might fit the bill. Treasury Inflation-Protected Securities, also known as TIPS, offer “real yields” – i.e., yields after inflation. As such, these unique securities provide a return stream that protects fixed-income investors against inflation – the “kryptonite” of the fixed-income world. (Click here to discover all the scintillating details about TIPS).

In yesterday’s edition of The Daily Reckoning, we presented a thorough case for selling Treasury bonds. We have not changed our opinion during the last 24 hours. Runaway budget deficits, and the resulting risk of inflation, provide more than enough reason to avoid T-bonds, if not also reason to sell them short. (Selling T-bonds is, in fact, one half of Bill Bonner’s, “Trade of the Decade.”)

The analytical team at The Daily Reckoning is well aware of the argument that Treasury bonds will rally and yields will fall as private sector credit contracts and the overall economy deflates. We are aware of this argument and we reject it.

Deflation is an attractive theory; inflation is a fact.

The astonishing magnitude and velocity of America’s deficit-spending mania will ignite an inflationary trend that will incinerate the deflationary influences operating on the US economy. TIPS investors seem to agree. The inflation rate implied by TIPS prices shows an expectation of rising inflation.

A little explanation may be in order here…

The yield differential between TIPS and a conventional Treasury security of the same maturity is called the “breakeven inflation rate.” This rate reflects investor expectations about future inflation. The higher the yield differential, the higher the implied future inflation rate. The chart below tracks the breakeven inflation rates during the last two years for the 5-, 10- and 30-year TIPS.

TIPS Breakeven Inflation Rates

You will note that inflation expectations collapsed during the depths of the credit crisis in late 2008. At one point, 10-year TIPS were pricing in almost zero inflation! But inflation expectations have been rebounding ever since. Today, 10-year TIPS anticipate an inflation rate of 2.39% during the next ten years – the highest anticipated inflation rate since July of 2008.

Admittedly, 2.39% is a relatively tame rate of inflation. And that’s just the point. If, as seems likely, the inflation rate accelerates over the next two years, TIPS investors will fare relatively well, while the holders of conventional long-dated Treasury bonds will be donning sackcloth and repenting of their faith in deflation.

Net-net, TIPS suck less. You heard it here first.

The Daily Reckoning