Sunday, November 23, 2008

Memo to Tim Geithner: Retire the TIPS

Before the Treasury decided to start issuing TIPS, I was a strong advocate for inflation-adjusted bonds. At the time, I felt that people were overly concerned with inflation. (That was the mid-90’s, and I think subsequent experience bore out that opinion.) I thought that the government should issue indexed bonds to, as it were, take inflation off the table – to give people worried about inflation the opportunity to hedge, and to reassure markets that inflation was not the government’s intention. This, I thought, would give macro policymakers the opportunity to experiment more, having effectively given assurances that, if their policies were lead to a bout of excessive inflation, they had every intention of nipping that in the bud.

But times have changed. A few economists may still be worried about the possibility of inflation at a long horizon, but the consensus of the bond market seems to be more concerned about deflation, particularly at a short-to-intermediate horizon. In fact, some TIPS appear to be trading at yields higher than the corresponding nominal Treasuries. That doesn’t make any sense to me, because, as I understand it, TIPS principal cannot be adjusted downward in nominal terms, which, if my logic is correct, means that, when you buy a TIPS at a yield higher than the corresponding nominal, you are guaranteed a higher return when you hold it to maturity.

I don’t feel like working out the algebra right now, but I’m pretty sure that kind of thing isn’t supposed to happen in a market with rational agents -- unless of course the agents don't realize that one another are rational. (I can see how it might happen in a CAPM-type model in which the agents don’t care about higher moments, since nominal Treasury returns might be negatively correlated with other asset returns; but this is a case where the higher moments obviously matter: whatever the means and variances might be, if portfolio A outperforms portfolio B under every possible outcome, then portfolio A is obviously better.) It’s certainly true that there is a liquidity premium in TIPS yields. But it’s hard for me to believe that the bid-ask spread on TIPS is large enough, or expected to become large enough, to justify the kind of yield spreads we’re seeing. Perhaps there is some other technical reason that I don’t understand.

Anyhow, rational or not, TIPS are obviously cheap today. Moreover, this is not a time when the government should want to reassure people of its intention to avoid excessive inflation. There is an overwhelming demand for safe assets, and the way to get people to invest in other assets is to take away the opportunity for safety. The US government should be happy to do anything that will make people worry that real Treasury returns are vulnerable to inflation. Not that I’m advocating intentionally high inflation: I’m just saying don’t make any promises.

Moreover, the government, which can issue its own Treasury bills whenever it needs access to cash, doesn’t have to worry about liquidity. The government should be happy to provide more liquidity to the market and to earn the liquidity premium in return. And if market agents are being irrational (as they apparently are), it’s in the public interest for the government to set them straight and to make a profit in the process, while also reducing its long term risks. So it is both good macro policy and good financial policy for the government to be on the buy side in the TIPS market.

I therefore recommend that the Treasury stop auctioning TIPS until further notice and begin bidding for TIPS in the open market with the intention of retiring them and issuing nominal securities in their place. When times change again, when inflation becomes a big concern in the market, when inflation protection is once again something that people are willing to pay for, then it may be a good time to start issuing TIPS again. Sell high, when you have the opportunity, but right now it’s time to buy low.


UPDATE: Foster_Boondoggle points out in a comment that my argument about irrational valuation doesn't apply to outstanding TIPS for which the principal has already been substantially adjusted for past inflation, since subsequent deflation will still reduce the value of the TIPS. So I was wrong to suggest that the market was necessarily irrational and that the government would be taking a sure bet by retiring TIPS.

However, I do think the government would be taking a pretty good bet, especially since deflation would give the government the ability to do virtually unlimited seignorage (thus more than compensating taxpayers for losing the inflation bet), whereas if there is greater-than-expected inflation, the government's borrowing costs will likely go up. In other words, if the TIPS-to-nominals spread is actuarially fair, then the government is getting a costless hedge by retiring TIPS. Also, my argument about the effects on expectations becomes stronger: by retiring TIPS, the government is explicitly betting against deflation, which should increase the market's confidence that it will try harder to avoid deflation.

31 Comments:

Blogger Abby Carmel said...

Hi! I'm an editor for Seeking Alpha. Please contact me at your earliest convenience at acarmel@seekingalpha.com. Abby

Mon Nov 24, 08:24:00 AM EST  
Anonymous Anonymous said...

The only promise TIPS hold, if I understand TIPS correctly, is that they fix the yield, at least in so far as it is affected by inflation. That is, the government is prepared to compensate the buyer for his or her losses that arise from subsequent actions taken by the government. Is that correct?
The government is in a sellers' market at this point, so does that mean that it should be less inclined to make promises? That depends on the role of government and who it is making promises to. There is a big difference between promising returns on investment to investors and promising the people you are elected to care for that you will take that responsibility seriously. The government should be in the business of the latter, not the former, so that probably means I agree with you.

Mon Nov 24, 09:30:00 AM EST  
Anonymous Anonymous said...

Increased inflation risk won't force people to loan money to risky private entities. Uncertain inflation risk makes loans to private entities even more risky. When uncertain inflation prospects loom, loans are out, and inflation hedges are in.

Potentially higher/erratic inflation would make the credit crises even worse. This is not the time to make private loans even more risky than they already are. This is the time to reassure people that loans are safe.

Mon Nov 24, 10:05:00 AM EST  
Anonymous Anonymous said...

TIPS are just forecasting deflation. The option-like effect you refer to - that the principal at maturity won't be less than at issue - becomes less & less relevant as a TIPS ages in the secondary market. A 10 yr TIPS issued last January already has an inflation factor of 1.045, so a buyer now can lose up to that much principal if there's deflation. The 5 year issued in April has a factor of 1.035. So you could lose roughly 75 bp/yr in nominal yield if cumulative deflation is more than 3.5% over 5 years. That's more than enough to account for the nominal vs. real yields observed in the market. You may not believe that there'll be that much deflation, but that's a bet, not an arbitrage.

Mon Nov 24, 02:32:00 PM EST  
Anonymous Anonymous said...

TIP's indexed principal values can and does go down if the CPI goes down - just not below the original par value. Existing outstanding TIPS with accumulated inflation adjustments will trade at real yields such that the discounted value of their cash flows is competitive with nominal treasuries given prevailing expectations about inflation and adjusting for the fact that TIPS are less liquid.

All of the above is not a reason to conclude that TIPS are "not working properly".

Perhaps if you actually own TIPS and modelled their cash flows you might reach different conclusions.

Mon Nov 24, 02:51:00 PM EST  
Anonymous Anonymous said...

I don't know about all this TIPS business, but when I worked as a waitress, I sure liked to get tips.

Mon Nov 24, 08:48:00 PM EST  
Blogger Richard H. Serlin said...

An interesting note on TIPS is that they are not the safest asset for all people. A big issue is the term. Last I checked, the shortest term was 5 years. If you end up needing the money back after two years, but real rates went up a lot, you could take a large loss selling your TIPS. You don't have that risk with a money market fund, where the securities are for terms less than 1 year, maybe far less.

And there's also tax risk, especially if inflation does heat up. You pay taxes on all of the interest, the inflation part and the real part. This can push the real interest to being negative.

Stocks move greatly with inflation, given that they are ownership of real assets, and have much higher expected real returns, plus the return is largely taxed at the capital gains rate, which is much lower at high income levels, so that's something to consider, at least for long run investing. Municipal bonds have tax free interest, another option to consider, especially for those in high tax brackets.

Fri Nov 28, 08:00:00 PM EST  
Anonymous no seat said...

polo ralph lauren
lacoste polo shirts
burberry poloscheappolos
polo fashion

Wed May 13, 09:38:00 PM EDT  
Anonymous Anonymous said...

http://www4.atword.jp/sportshoes/
http://www.actiblog.com/sdfsdfsd/
http://d.hatena.ne.jp/iblog99/
http://kurumaro.com/pumashoes

Thu Jun 11, 09:28:00 PM EDT  
Anonymous yes said...

http://yes.allili.com/

Mon Jun 15, 06:09:00 AM EDT  
Anonymous Anonymous said...

http://yes.allili.com/

Mon Jun 15, 06:10:00 AM EDT  
Anonymous Anonymous said...

http://yes.allili.com/

Mon Jun 15, 06:10:00 AM EDT  
Anonymous Anonymous said...

單立文
美甲
激光矯視
鼻咽癌
子宮頸癌疫苗
BMI
糖尿病
瑜珈
中風
美白
脫髮
身體檢查
大腸癌病徵
牛皮癬治療方法
乳癌特徵
整容
減肥餐
哈啦論壇
守護甜心漫畫
火影忍者疾風傳
花漾明星
唱 k 小魚仙遊戲
衝鋒 21 動畫
涼宮春日的憂鬱
寵物小精靈鑽石珍珠
海賊王漫畫連載
gundam 00 官網
黑執事 wallpaper
寵物小精靈綠寶石
one piece 漫畫
龍珠 z
數碼暴龍 online
小女神花鈴漫畫
keroro 軍曹主題曲
多啦 a 夢大電影
花樣男子
省電妙招
無名挖挖挖
洗米水的用處
婚紗
李敏鎬
大樂透
地球很美有賴你
星座運勢
楓之穀遊戲
守護甜心漫畫
黃金價格
瘦小腹魚湯

Mon Jun 15, 07:18:00 AM EDT  
Anonymous Anonymous said...

I like your blog . They are really great. Ermunterung ++ .please pay a return visit to my blog .thank you.
http://www.soulcast.com/iblog99/
http://iblog99.jugem.jp
http://iblog99.cocolog-nifty.com/blog/

Sun Jun 21, 10:22:00 PM EDT  
Anonymous all said...

We possess professional anime cosplay costumes with an abundant designing strength. High quality Black Butler Cosplay and Anime Cosplay Costume On Sale. You can dress naruto cosplay up for Cosplay show. Cheap Cosplay will feature an array of gently used Halloween Cosplay Costumes and accessories in adult and children’s sizes. Individuals interested in donating Wholesale Costume can drop them off. Wright Elementary through the day of the sale. A collection of Japanese School Uniform,cosplay naruto,Final Fantasy Cosplay,Bleach Cosplay,Kingdom Hearts Cosplay is hot sale now.

Wed Sep 30, 02:10:00 AM EDT  
Anonymous Anonymous said...

I like your blog, it's very good!
By the way, do you like spyder ski jackets, I think they are very fashionable and chic, especially the kids north face jackets, I love them so much. In my spare time, I also like playing tennis racket, it can keep healphy, what do you like to do?
polo vest
polo jacket
polo jackets
polo jackets for men
polo jackets for women
polo hoodies for men
polo hoodies for women
polo sweatshirts for men
polo sweatshirts for women
polo shirts for men
polo shirts for women
polo shirts wholesale
polo shirts for girls
ralph lauren polo shirt
polo pants for men
abercrombie fitch shirt
wholesale abercrombie fitch shirts
abercrombie fitch mens shirts
burberry shirts for men
burberry shirts for women
burberry shirts on sale
nroth face jackets on sale
nroth face jackets cheap
nroth face jackets for women
nroth face jackets for men
columbia jackets women
columbia jackets for men
columbia jackets discount
spyder jackets for men
discount spyder jackets
cheap spyder jackets
spyder jacket
spyder jackets for women
tennis rackets
cheap tennis rackets
discount tennis rackets
tennis rackets on sale
prince tennis racquets
head tennis racquets
wilson tennis racquets

Mon Nov 02, 12:56:00 AM EST  
Blogger Unknown said...

designer sunglasses
Cheap shoes online
Wholesale Polo Shirts
Chaussures Sport
MBT shoes
cheap cell phones
sports shoes
nike tn air ma
clothes jeans
nike shoes

Mon Mar 29, 05:08:00 AM EDT  
Blogger winnie said...

moncler
moncler branson
moncler jackets
moncler jacken

bandage dress
herve leger bandage
herve leger

Dsquared sneaker for men
Dsquared2 jeans
Dsquared2

Moncler
Moncler Jacket
Moncler jackets

Thu Oct 21, 10:52:00 PM EDT  
Blogger weddingdresses said...

power balance is said for optimal peak performance by your body it is important to keep an ionic balance and good flow of energy through pathways at your bodies optimum frequency. Apparently after years of research and development power balance bracelet has developed a method to safely and immediately restore and optimize the energy balance with in your body.
winter boots

Thu Dec 30, 05:14:00 AM EST  
Blogger cosplay costumes said...

fantastic blog~~welcome to our website :mylove-dress.com .More cheep and beautiuful wedding dress for you~~~

Wed May 11, 10:18:00 PM EDT  
Anonymous Anonymous said...

black boots

Chocolate boots

sand boots

Chestnut boots

gray boots

pink boots

grey boots

Ugg Boots For Sale

Sand Ugg Boots

Sat Aug 20, 04:27:00 AM EDT  
Blogger Frank said...

Hey,
Loving your blog, awesome tips on blog you have here. I
would just like to ask you some questions privately, mindWinRaR Free Download,IDM Free Download,function venues geelong,la Fitness,Mobile Prices in Pakistan

Sat Aug 27, 06:06:00 PM EDT  
Anonymous London Escort Agency said...

Your Escort Agency offers exclusive and most beautiful London escort girls of various nationalities.

Thu Sep 29, 06:36:00 AM EDT  
Blogger Mohtasham said...

Man I must say your mind works regarding all the this. I learned alot from your article keep teaching us more. I really appreciate you and want to talk you please tell me how can contact you? how to cook biryani l latest sms l la fitness

Fri Oct 07, 06:29:00 AM EDT  
Anonymous London escorts said...

Bestescort4U agency provids best London escorts companionship in the UK.

Mon Oct 31, 05:10:00 PM EDT  
Blogger Unknown said...

Moncler Outlet Store
Uggs clearance
Uggs on clearance
Uggs sale

Fri Nov 25, 04:08:00 AM EST  
Anonymous fix credit score said...

instead of retiring the TIPS he ought to just retire.

Tue Nov 29, 02:01:00 AM EST  
Anonymous 스포츠 토토사이트 - JDSD said...

Thanks for sharing your this great work of yours.

Sun Dec 17, 10:00:00 AM EST  
Anonymous 바카라사이트 백링크 - JDS said...


Wow this blog is awesome. Wish to see this much more like this.

Sun Dec 17, 10:01:00 AM EST  
Anonymous 메이저사이트 백링크 - JD said...

Nice post, keep sharing such post.

Sun Dec 17, 10:02:00 AM EST  
Anonymous 먹튀검증 안전놀이터 백링크 - J said...

Hello, nice to read your all blogs and learned a lot of new knowledge. Thank you!

Sun Dec 17, 10:04:00 AM EST  

Post a Comment

<< Home