January 16, 2010

The Tipping point

Filed under: Uncategorized — ktetaichinh @ 7:05 am
Tags: , ,

Surveys are so 20th century. Whether it is the timing of the next rate hike, oil price expectations or even the outcome of presidential elections, economists now accept that the collective wisdom gleaned from thousands of financial bets often proves more prescient than experts’ consensus. But they may be placing too much faith in an emerging barometer of inflation expectations, US Treasury inflation protected securities.

The difference between vanilla Treasuries and Tips yields in theory conveys a pure bet on consumer price inflation. Tips’ recent 242 basis point spread below 10-year Treasuries – implying average US CPI of 2.42 per cent over a decade – is the highest since the Lehman debacle. This is also above near-term inflation forecasts and the 2.22 per cent average over the past decade. Traders reckon this reflects anxiety over ultra-low rates and fiscal profligacy.

Other explanations are likely. For one, Tips are relatively scarce, representing just $600bn out of $7,800bn in Treasury debt held by the public. Foreign creditors have encouraged the Treasury to boost issuance, which will reach a record $80bn this year, a big increase on 2009’s $58bn. Even after supply rises though, it remains likely that Tips will not serve as a completely reliable inflation gauge. Given conflicting predictions of surging inflation or crushing deflation as the recession’s hangover, investors may pay a premium for Tips’ embedded optionality – they gain from inflation but earn no less than their nominal coupon in the case of deflation.

The inflation protection embedded in Tips is thus akin to a call option rather than a futures contract, an important distinction. Tips’ cheapness as a government funding source is illusory since it is letting buyers make an asymmetrical bet on prices. The US Treasury should pray these options expire out-of-the-money.


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