TIPS for investing and predicting inflation

A lot of people are worried about inflation because of hysteria at the Wall Street Journal and other media reports that sensationalize the issue.  I’m not worried because I trust the bond market which predicts inflation better than anyone.  To understand how, you have to understand TIPS. 

“TIPS” are Treasury Inflation-Protected Securities. They are government bonds that pay a real interest rate (r) plus the actual inflation rate (π). Regular government bonds pay a nominal interest rate (i). These three variables are inherently related to each other by a simple equation:

r=i – π

To see how this equation works, suppose you have an ordinary government bond that is paying 8% nominal interest (i) and the inflation rate (π) is 3%, then your real return on investment isn’t 8% because the real value is decreasing by 3% per year. The real return on investment is 8% – 3% – 5%.

Now if inflation were always a constant rate, then regular Treasury bonds would be identical to TIPS because TIPS pay (r+π) which is equal to i. (Because if we rearrange the above formula, you also see that i=r+π). The difference between TIPS and regular Treasury bonds is that nobody knows what the future inflation rate will be when they buy bonds and so

  • if you buy TIPS, you know what your real interest rate (r) will be but you don’t know what your nominal payout will be (i).
  • if you buy regular Treasury bonds, you know what your nominal payout will be (i), but you don’t know what your real payout (r) will be.

If you are investing in government bonds and you are sure that the inflation rate will be 2%, then you will be indifferent between a TIPS that pays 3% (plus inflation which you expect to be 2%) and an otherwise identical Treasury bond that pays a nominal 5%. This fact makes it possible to see what the multitudes of bond traders thinks the inflation rate will be in the future. The US Treasury bond market is the deepest security market in the world with over $20 trillion in 2020 and every bond trader will lose a lot of money if they estimate future inflation wrong, so they have immense incentives to get it right because if ordinary bonds are paying i=5% and TIPS are paying r=4%, but you think inflation will be 2%, then you can make 1% higher real return on investment by buying TIPS (r=4%) than the 3% you would earn by buying ordinary bonds (r=i – π = 5% –2%= 3%).

To estimate the bond market’s expectations of future inflation, just look up the interest rate that ordinary treasury bonds pay (i) and subtract the interest rate that TIPS pay (r) because i-r= πexpected. The St. Louis Fed posts a graph of the bond market’s inflation predictions which are called the “breakeven inflation rate” because it is the inflation rate that makes the real return break even on both kinds of bonds:

The vertical orange line shows when the inflation predictions inverted in January 2021. Before then, the bond market was predicting that inflation would be higher in the long-term (over 20 and 30 years) than in the short term (5 years). Since the beginning of 2021, the market has been predicting that inflation will be higher in the short term than in the long term. Unfortunately, the US Treasury doesn’t have 1-year TIPS, so we cannot easily show a graph of the market’s inflation predictions for the coming year.

Technically, there should be some slight differences between the breakeven inflation rate shown here and the real inflation expectations mainly because ordinary Treasury bonds should have a higher return because they have inflation risk whereas TIPS do not, so investors should be compensated with a higher reward on Treasury bonds, but this is a very minor factor that is counterbalanced by the fact that investors also need to be compensated for the lower liquidity of TIPS which drives up the interest rate on TIPS and counterbalances the other forces.  Most analysts ignore this kind of complexity and simply subtract the two interest rates to find expected inflation:

πexpected=i–r

The most useful estimate of future inflation is the 5-year breakeven rate because it is the shortest prediction we can easily infer from the markets. Short-range projections are the most useful because they are more accurate than long-range predictions and humans find short-range forecasts more useful because we naturally discount the future more as time gets more distant.

Currently, the bond market predicts that the 5-year inflation rate will be higher than the 30-year inflation rate:

Picture1

Unfortunately, FRED doesn’t show bond-market data for the most recent couple weeks, but it is easy to find more up-to-date graphs elsewhere:

As shown here, the markets’ inflation worries have subsided considerably in the past two weeks. Remember that this is a prediction of the average inflation rate over the next five years, so a half percentage point decrease as shown here is really a pretty dramatic movement in such a long change in inflation over the next five years

Should I invest in TIPS?

If you are going to invest in government bonds then you should invest at least part of your portfolio in TIPS because

  1. Diversification: TIPS are very similar to ordinary government bonds, but their returns are uncorrelated when inflation swings, so they help reduce risk.
  2. Lower risk: TIPS are also inherently less risky than ordinary government bonds because there is zero risk of an unexpected rise in inflation eating up your real return on investment. There is no other investment that can guarantee you what your real return on investment will be like that. The main advantage of government bonds is that they have lower risk than any other investment (at maturity) and TIPS are the safest kind.
  3. Higher average real payoff than regular bonds so far!  Because the bond market has underestimated future inflation, TIPS have actually paid a slightly higher average ROI than regular bonds according to the Treasury’s analysis!  This also means that the bond market is a slightly biased estimator of future inflation as mentioned above, but it isn’t a large amount, and nobody predicts future inflation better than the bond market so I’m not going to get too critical that it isn’t perfect.

In theory, the main drawback TIPS should be that they should have slightly lower average real return than ordinary bonds because of their lower risk, but so far they haven’t!  You can actually get lower risk AND slightly higher return with TIPS.  If you are investing in government bonds, then you are obviously wanting low risk, so you should be also thinking about TIPS then too.

The weird thing about TIPS right now is that they pay a negative real interest rate (plus inflation) and unsophisticated investors might prefer ordinary bonds that pay a positive nominal interest rate because it feels weird to lock in a guaranteed real loss in value as shown by the blue line in the graph below:

TIPS currently pay a negative interest rate of almost -2% (plus inflation) whereas ordinary treasuries pay a positive nominal interest rate of over 1%. The gap between the two lines in the above graph is i-r= πexpected which is the 5-year average expected inflation rate. If the bond market is correct about future inflation, then both kinds of bonds will pay the same ROI, but only TIPS guarantees a real ROI.

Posted in Macro

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