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TIPS Reaches an All-Time Record Low of -1.67%. What Are the Implications?

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The 5-year note is the most overvalued in history.

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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).
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