We’re seeing heated debate in regards to the fact that the yield on U.S. treasury inflation-protected securities (TIPS, ie. inflation-protected government bonds) has fallen below 0%, ie. the bonds provide a negative real yield.
To me, this is pretty astounding. There are investors who are willing to stash their money away for five years, just to get no real return for it. They’re terrified to step off the pier even a tiny bit.
Here’s a chart of the situation from Mr. Salmon, with the TIPS yield in blue:
Thing is, while the negative real yield for these inflation-protected bonds is shocking, since as Paul Krugman puts it, investors are willing to buy “a safe asset that doesn’t quite keep up with inflation,” if TIPS yields hadn’t fallen to where they are now, then we’d truly have something to worry about — Deflation.
This is because the TIPS yield is really a function of standard U.S. government bond yields and expected inflation. Hence the TIPS yield always has to be viewed in relation to the inflation forecast it implies, not its absolute yield in isolation.
As we highlighted a few days ago, this is done by looking at the difference between the TIPS yield and the yield for standard government bonds. This is called the TIPS spread, here’s the chart we did a few days back on it:
What the chart shows is that as standard U.S. bond yields fell during the end of July and early August (see the red line via Felix Salmon’s chart at the top of this post), inflation expectations didn’t collapse during the period… because TIPS yields fell roughly in unison, bringing them below 0%.
If the TIPS yield hadn’t fallen in unison with standard bonds, then it would mean that markets were now expecting far less inflation than before, since the TIPS spread we show above would have collapsed. This would be a truly ominous situation for anyone who believes deflation is a problem.
So while the negative/near-zero TIPS yield is startling, the alternative, ie. a higher yield, would be far more shocking since, if it were significantly higher right now, it would imply that markets had lost confidence in the Fed’s ability to fight off deflation. Hope this doesn’t happen, the verdict is still out.
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