TIPS Look Cheap Next to Treasuries

If an economist who had slipped into a coma circa 1979 awoke today and surveyed the scene, what would he find? Let's tick down a list: Gold over $700 per ounce, crude oil futures at record highs, the dollar at a new low against the euro, the Federal Reserve and its fellow central banks poised to cut short-term interest rates, etc. Our groggy-eyed practitioner of the Dismal Science could be forgiven for thinking the world of double-digit inflation had continued.

Now tell him we have had this instrument called TIPS since January 1997. Not only is their payoff linked to changes in the All-Urban CPI (consumer price index), not seasonally adjusted (CPI-U), but their yield gap or "breakeven rate" to conventional Treasury bonds can be read as a measure of expected inflation. He would have to chuckle at what this measure would say.

Go ahead, ruin his day. At the time of this writing, the expected rate of inflation is 2.254%, up from 2.19% after the release of August employment data on Sept. 7. As recently as May 2006, this rate was just over 2.7%. But really, who among us really believes the CPI-U will average 2.254% over the next 10 years? Is this what the TIPS market is telling us, or is there another process afoot?

Inflation Insurance

As discussed last December, we can view the TIPS market as insurance against inflation. Both the U.S. Treasury and the many purveyors of TIPS products would like you to believe this insurance is either free or very cheap. It is neither, which is exactly what you should expect.

The cost of the insurance, which is paid by you, the investor, in the form of a lower yield received, should equilibrate the prospective total return of TIPS and Treasuries. Any actual gain from holding TIPS has to derive from future reported inflation coming in higher than the breakeven rate at time of purchase.

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Howard L. Simons is president of Simons Research, a strategist for Bianco Research, a trading consultant and the author of The Dynamic Option Selection System. Under no circumstances does the information in this column represent a recommendation to buy or sell securities. While Simons cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.

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