On September 14, the five-year TIPS (Treasury Inflation Protected Securities) closed at -1.67%. This is the all-time low for any TIPS security ever. The majority of investors would have exposure to TIPS through something like the PIMCO TIPS Index Fund
(NYSEARCA:STPZ) or the iShares Barclays TIPS Fund
Anytime any indicator or security hits an all-time extreme it means something highly unusual is going on. Let’s take a closer look at the five-year TIPS to see if we can derive any implications from this extraordinary reading.
Let’s take a look at the charts:
Since we can’t really compare the current situation to a previous TIPS bottom, let’s look at the big TIPS top. On November 26, 2008 the Five-Year TIPS reached its post 2002 high (data on the Fed website starts January 1, 2003) of 4.24%. Note the Fed announced QE1 the previous day. The 5-year note was yielding 2.01%. Since then, the 5-year TIPS has dropped by 139% and the 5-year yield has dropped by 64%.
So over the long run, that was a good time to buy both TIPS and the 5-year note.
On September 14, 2012, buyers of the 5-year TIPS were locking in a -1.67% real return. The modern day rendition of the old Henry Youngman joke for this is “Take my purchasing power. Please.”
Is the 5-year TIPS a worse investment than the 5-year nominal note? Well that depends on whether or not inflation will be above or below 2.39% annualized over the next five years.
Since January 2003, TIPS five year implied inflation predictions have ranged from -2.24% to 2.94%. The average anticipated inflation was 1.95%. The actual five-year annualized inflation ranged from 1.89% to 3.67%. The average actual inflation was 2.50%. The forecast error ranged from -2.12% (underestimated inflation) to 0.82% (overestimated). The average forecast error was -0.2%. The reason why that number is a not the exact match between the anticipated and actual averages (1.95%-2.55% = -0.55%) is because there is an extra 60 months of data for the predicted inflation rate. In any event, if TIPS are systematically undervalued by a little bit, it suggests that they are typically a better bet than normal Treasuries (unless one has a strong opinion of less than anticipated inflation). Since if the 5-Year TIPS was the most overvalued inflation-indexed Treasury security in history a few days ago and TIPS are historically better than nominal notes, its means that the five-year nominal note is really a bad deal. On September 14, you were getting a whopping 0.72% annualized return at a time when Ben Bernanke has said he was going to print until the unemployment rate goes down by a decent amount. While most treasury security yields hit their low on July 25 and have come up a bit, Treasuries are arguably even more overvalued now than they were at their July 25 lows (since we didn’t know for sure back then that QE3 was coming). Bernanke extended ZIRP to 2.75 years of the 5-Year Note’s life. The five-year note yield has climbed from its low of 0.56% on the epic July 25 bottom to 0.72% for a total of a 0.16 point yield move.
On the other hand, the 10-year has gone up 0.48 points and the 30-year yield 0.62 points. In other words, longer term securities have a lot more time for a Fed Chariman to raise interest rates. Investors who want to buy the 5-Year Note soon are stuck in the worst possible spot. Interest rates won’t be raised for most of its lifetime but inflation will probably go higher. While the fact that interest rates won’t be raised for 2.75 years offers some protection to current investors from price depreciation, it is a small consolation against the ravages of inflation.
The historical average TIPS for the 5-year post 2002 is 0.99%. So right off the bat TIPS is trading 2.66% below historical yields (–1.67% – 0.99%). This would suggest that the 5-Year Note’s “Fair Value” is 0.72% (5 year yield) + 2.66% (below historical value) = 0.99% (typical real return) + 2.39% (expected inflation) = 3.38%
(fair value). Since 1962, the 5-Year note has traded at an average yield of 6.37% while the average inflation rate has been 4.16%. This method suggests that investors typically demand a 2.21% real return for the 5-year bond. Using the 1962 data method, the “fair value” of the 5-Year Treasury would be 2.39% (expected inflation) + 2.21% (real return) = 4.6%
So we have a “Fair Value” range for the 5-year note from 3.38% to 4.6%. This suggests yields would need to go up by 369% to 538% to reach fair value.
In summary, on September 14, 2012 the five-year note was the most overvalued in its history. Sell.
No positions in stocks mentioned.
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