Bailout

Chart of the day: TIPS yields

By Felix Salmon

Paul Krugman notes today that 5-year TIPS are trading with a negative real yield, which prompted me — with the help of the great Frank Tantillo — to navigate the Fed’s data download program to generate this. (Bigger version here.)

Both 5-year and 10-year TIPS yields are trading at or near their all-time lows right now (the chart only goes up to the close of business yesterday, and yields have fallen again today).

I’m a bit stumped, however, on what exactly this means. The last time that TIPS yields dropped below zero, the cited reason was “investor speculation that inflation will quicken as the U.S. economy slows”. But that doesn’t seem to be the case right now, with the 5-year Treasury at 1.44% and the 10-year at 2.71%.

So what’s going on? Scott Grannis has his own ideas, which don’t bode well for the medium-term future of the economy as a whole:

You can think of real yields on 5-yr TIPS as a good proxy for the market’s expectation for real GDP growth, mainly because there should be some reasonable connection between the risk-free real yield an investor can earn on TIPS over the next 5 years and the real yield on cash flows tied to the economy’s performance via generic equity exposure. For example, if expectations for economic growth were healthy (e.g., 4-5% real GDP for the next several years), then an investor would be foolish to put his money in 5-yr TIPS that promised a zero real return. Cheerfully buying 5-yr TIPS with a guaranteed real yield of zero only makes sense if one has very grave doubts about whether the economy can generate any real growth at all in the coming years.

I don’t think that the TIPS market is pricing in zero real GDP growth over the next 5 years. But I do think it reflects worries over stock-market valuations. A stock-market investor only gets exposure to the economy’s performance via investing in equities if p/e ratios don’t fall, after all, and I can easily imagine a scenario where the economy grows modestly, or enters a shallow recession, while stocks fall significantly.

So my feeling is that this is the “there’s nothing else to buy” trade: a desperate lunge for safety in a world where everything else — including stocks and property — looks decidedly risky. Although with yields this low, even these long-dated TIPS stand to drop quite a lot in value if they revert to their mean yields.

Full post as published by Macroprudential on August 11, 2010 (boomark / email).