Wednesday, February 11, 2009
What's happened to TIPS?
One of my colleagues points out that the Cleveland Fed is no longer tracking expected inflation using data from the TIPS market.
Now the inflation risk would seem to be higher; if you are in a world where some people shout "hyperinflation!" and others shout "deflation!", you can be pretty sure inflation uncertainty went up. That would push down the yield on the inflation-protected security, because the buyer is transferring that risk onto government. But if the TIPS market is less liquid -- even more so with the flight to safety underway -- we have a big counterweight. After seemingly inflation risk was increasing in December and early January, we're seeing some closing of the gap as real yields appear to be increasing -- or the liquidity premium rose -- or the deflationary threat is perceived more real -- or...
And if the FED is doing the Twist around the 10-year note, I have no idea what the spread means. But one thing is clear -- a gauge of expected inflation has been disrupted in the market.
We have discontinued the liquidity-adjusted TIPS expected inflation estimates for the time being. The adjustment was designed for more normal liquidity premiums. We believe that the extreme rush to liquidity is affecting the accuracy of the estimates.Interestingly, yesterday the New York Fed held a conference inflation-indexed securities and risk management. Fleming and Krishnan presented an interesting paper on the TIPS security. They explain that the spread between same-maturity Treasuries and TIPS actually contain two premia, one for liquidity and one for inflation. They normally work in opposite directions. But look here, at the last 12 months for the 10-year bonds indexed (blue) and unindexed (green).
Now the inflation risk would seem to be higher; if you are in a world where some people shout "hyperinflation!" and others shout "deflation!", you can be pretty sure inflation uncertainty went up. That would push down the yield on the inflation-protected security, because the buyer is transferring that risk onto government. But if the TIPS market is less liquid -- even more so with the flight to safety underway -- we have a big counterweight. After seemingly inflation risk was increasing in December and early January, we're seeing some closing of the gap as real yields appear to be increasing -- or the liquidity premium rose -- or the deflationary threat is perceived more real -- or...And if the FED is doing the Twist around the 10-year note, I have no idea what the spread means. But one thing is clear -- a gauge of expected inflation has been disrupted in the market.
