Inflation Has Subsided, but for How Long?

It is hard to believe that oil was $140 a barrel as recently as four months ago. Way back then, inflation was the front and center concern for most investors as the Consumer Price Index popped an amazing 1.1% in June alone. Times have certainly changed since then and the most recent CPI numbers showed an actual contraction (although very small) in prices. The source of this about face is obvious: Oil and commodities-not-named-gold have dropped precipitously in price, and assets like homes continue to lose value. The evidence clearly points to it being a deflationary environment in the short term.

So why on Earth would we recommend buying Treasury Inflation-Protected Securities if all the evidence points to deflation? For the simple reason that you should buy insurance before you need it, not when it is too late.

Take a look at the five-year chart below that compares monthly changes in annual CPI with the TIPS spread. The TIPS spread is the difference between TIPS yields and the corresponding Treasury yield. This is commonly referred to as the "inflation break even yield," meaning that as long as inflation is greater than the TIPS spread you are better off owning TIPS than Treasuries.

As you can see, the TIPS spread has fallen off a cliff the past several months and it is trading well below its five-year low. As of the writing of this article, the 10-year TIPS spread was below 1% and has been bouncing negative from time to time over the past few weeks.

There are a couple of things driving this. First of all, shorting Treasuries and going long on TIPS was a very popular hedge fund strategy over the past couple of years. Borrowing short-term debt and buying long-term securities is an easy way to make a quick buck in a liquid market, but in a credit tightening the fund will blow up quicker than you can say "margin call." As a result, we believe there has been a lot of forced selling on the market as the cost and availability of short-term credit dried up.

The other reason is that, in the near-term, inflation is not going to be much of a problem. The global economy is going into recession and the asset bubble from the go-go years of the past decade is still deflating. For how long this flat or deflationary environment will last should be one of the biggest debates raging in economic circles and it probably would be if the credit markets weren't melting down. On one hand, we have prices easing across the board. On the other, the government as been printing money and pumping it into the financial system at an incredible rate, which further clouds the issue.  

Either way, the point is that TIPS should be attractive to long-term investors right now precisely because expectations for inflation are low. You don't want to buy flood insurance after the river is in your living room. By then, it is too late and the price of protection is too high. We recommend that you keep TIPS on the radar and consider allocating a bit of your portfolio to them, but don't back up the truck just yet. The deleveraging that we spoke of is still working itself through the system and there could be some unpleasant bumps over the next few weeks.

Investors looking for some insurance against inflation should take a look at a few different funds. In the ETF space,  iShares Lehman TIPS Bond ETF (TIP) currently sports a 7% yield, an effective 7.21 duration, and a cost of 0.20%. In the open-end mutual fund space  Vanguard Inflation-Protected Securities (VIPSX) is one of our favorite funds. It currently has just under a 6% yield, a 7.60 duration, and a similar cost of 0.20%. We also like  Harbor Real Return Institutional  managed by PIMCO. Its yield is a little lower at just under 4% and the management fee is a little higher at 0.56%. As a final word of caution, the yield on TIPS is variable with inflation, so investors shouldn't think that they've locked in the above yields.

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