TIPS Prices Dispute Commodities Market, Consumer Inflation Views

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Conventional wisdom is that markets are the best place to get unbiased forecasts, but we see a sharp divergence of views between what TIPS buyers and Treasury traders in general anticipate inflation rates will be versus consumer expectations and the continued high inflows of new funds into commodities. We’ve seen this sort of divergence before. For instance, last year, the credit markets registered much greater concern about financial institutions and the economy that did the stock market (even after it fell briefly into an official bear market).

TIPS buyers aren’t alone in this view. Merrill Lynch chief North American economist, David Rosenberg, in a recent research note, “Dubunkging five myths” (hat tip Michael Shedlock) argued that the prospects for the economy were far worse than widely depicted. His detailed forecasts show US GDP growth of 1.1% in 2008 to be followed by 0.5% in 2009 (!) and the GDP price increase of 2.7% in 2007 to be followed by 2.1% in 2008 and 1.1% in 2009. He also sees CPI increasing 3.6% in 2008 and 1.5% in 2009.

From Bloomberg:

Treasury bond traders are telling Americans to stop fretting about inflation.

Consumers expect prices to rise 5.2 percent in the next 12 months, according to a monthly survey by the University of Michigan in Ann Arbor….Treasury Inflation Protected Securities, or TIPS, show traders anticipate inflation of about 2.9 percent by January, in line with its average of 3.1 percent the last 20 years.

The disparity has never been wider. ….TIPS say the commodities market is a bubble about to burst. A commodity slump would worsen losses in the $500 billion TIPS market, where investors lost 2.35 percent in April, the most since December 2006.

“There’s a lot of people who just don’t believe the economy’s going to stay strong enough to keep prices of things where they are,” said Chris McReynolds, who trades TIPS in New York at Barclays Plc, the largest dealer of the securities. “Part of what’s going on here is a lot of people view this price rise in oil, a lot of commodities, as being somewhat bubbleish and that they’ll come off again very quickly.”…

“What has not been going up is housing prices, what has not been going up is electronics, what has not been going up is apparel,” said Gang Hu, a TIPS trader at Deutsche Bank AG in New York. Consumers “buy food everyday, they buy gas everyday. As a result, if you ask them have you seen inflation, they will say yeah, because everyday they are informed there is inflation.”….

Consumers are responding to a jump in the cost of food and oil, even as prices of less frequently purchased items like cars, plane tickets and hotel rooms fall…..

The economy won’t grow at all this quarter, marking the worst slowdown since the 2001 recession, according to a Bloomberg News survey of 80 forecasters. Inflation will slow to 2.5 percent by the first quarter of 2009, the least since August, according to a separate poll…

Consumers and TIPS traders both influence Federal Reserve policy makers, who study the two groups’ inflation expectations when making interest-rate decisions, said Brian Sack, a former research manager at the central bank…

The Fed’s decisions are more complicated when the two groups are “giving different signals,” Sack said. “The measures carry more weight when they’re all moving in the same way and telling a similar story.”….

“It’s almost ingrained in the psyche of the market that people think ultimately inflation will recede because the economy’s slowing down,” said George Goncalves, chief Treasury and agency debt strategist in New York at Morgan Stanley…..

“The consumers are more right” than TIPS traders, said James Evans, who manages $4 billion of inflation-linked bonds at Brown Brothers Harriman & Co. in New York. “TIPS breakevens have continuously underestimated inflation.” …

Regular Treasuries are also pointing to a slowdown in price gains. In the last six months, yields on 10-year notes traded below the inflation rate for the first time since 1980. Over the past two decades, yields averaged 2.87 percentage points more than inflation.

The open question is growth rates in emerging economies. The IMF has revised global growth forecasts down each of the last two quarters, and the UN now projects the world’s economic growth rate at 1.8%. Anything below 2% is considered a global recession.

While a US slowdown doesn’t have the impact it once did, there are separate reasons to think that developing markets will cool off, alleviating demand for commodities.

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  1. S

    The entire no inlflation thesis is predicated on the notion that the debt at the Fed is money good. When the market realizes it isn;t and will be monotized the genie will have been long out of the bottle. If I am not mistaken the fixed income markets weren;t a great predictor of the August meltdown either…

  2. john jansen

    Bloomberg quoted the size of the TIPS market as $500 billion. That seems rather large. Secondly, last week when the CPI data printed friendly (bond market friendly) the market for TIPS bonds and nominal bonds acted counterintuitively. The spread actually widened when it should have narrowed as the friendly data should have worked in favor of the nominal bond but did not. traders attributed that to the belief that seasonal factors overstated the weakness this month but will magnify inflation next month

  3. Vijay

    It’s possible to have monetary deflation (which would suggest an increase in bonds prices, and a decrease in yields) while simultaneously having a price inflation (if demand for the currency goes down, commodities priced in the currency will go up). The trouble most economic commentators seem to have is that they don’t differentiate between price inflation (a poorly defined measure) and monetary inflation/deflation (as defined by the Austrian school).

    I recommend this article by Mike Shedlock and this article.

  4. Richard Kline

    A problem with the monetary deflation concept is deflated in comparison to what? We have had a colossal monetary _inflation_ in the US via uncovered debt creation at the currency level and credit creation at the retail level for thirty years, with a huge spike over the last half dozen years. A major contraction in credit creation and in false pricing could still leave price activity above long term (post Thirties Depression) trends. For example, equities have not price-corrected AT ALL to this point. Externally driven upward price pressures on imports of all kinds including many commodities only exacerbate the upside.

    I’m not posing this as a simple question; it isn’t. But despite asset price declines in the US we are far still from outright deflation by any definition. If and when assets fall below long-term trends or just approach them, we have ‘real delation.’ Don’t ask me where that is precisely, but someone can and should be calculating that. If medium-sized, creditworthy businesses with customer demand can’t get operating credit, we are deep in a deflationary spiral. We’ll know when we get there, it it happens. Personally, I think the Powers That Be will monetize debt and push us into a near hyperinflationary state at some point—because they can, while deflation is much harder to fight.

  5. Richard Kline

    One way that the public authorities in the US could and may try to ‘inflate our cares away’ is to issue interest on the repoed junk they are holding, or deliver ‘operating credits’ of various kinds to swap-meet banks. That would be unsterilized intervention in the guise of ‘normal lending activity.’ When an as we hear such talk, we’ll know that real deflationary pressures are biting hard.

  6. RK

    Show me a citizen who uses TIPS to protect him/her self against inflation (inflation as defined by USG, Boskinized and hedonized) and I’ll show you a moron, who buys a health insurance policy with a million dollar deductible.

  7. Anonymous

    rk is right–I am extremely concerned about inflation but would never buy TIPS as a hedge because the government is the entity who will be determining that inflation rate, and their inflation numbers are a joke.

    Was it here or somewhere else that I saw the article the other day about why the bond market was no longer able to police inflation?

    Moe Gamble

  8. S


    I agree credit spreads started moving in June, but that was a month before the actual event. I guess I was trying to make the point, sloppy as usual, that the irony is fixed income market long knew (participants) that the bubble was massive, but the price of inaction trumped all else. In short, the markets are not really an efficient discounting mechanism in the short run as we know from history. As an aside, if the markets only reflected the bubble one month proir to the eruption, what does that say about preventing bubbles?

    I recall speaking with a major IB internal risk person who predicted in late ’06 that they expected the wheels to come off in 2Q:07. They ended up being short subprime. Subprime was not a black swan event at all. It was fully expected almost universally across the Street, it was just too expensive not to play. Sort of like commodities right now.

    We are a long way from d-day in the whole debt/Fed/Consumer hot potato game. Also, while I agree printing is in the offing to replace the bad debt, Mish will eventually be right about full blown deflation. That after all is what occured in 1930s.

    RK makes a very good point about defining mean. The Fed defines mean as 2006 which is of course ludicrous. There is no such thing as high and low equilibriums. There is a market clearing equilibium and the longer we try and reverse the pull of gravity the more painful it will be.

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