TIPS Update: Lower yields, but still attractive
Scott F. Grannis - Economist for Western Asset
August 2000
With the passage of time we continue to gain new insights into what drives the TIPS market. It's a complex interplay of forces that does not always produce the results that conventional wisdom would suggest.
Observation: from their peak in January, real yields on TIPS have fallen about half as much as the 90 to 100 basis point declines in 10 and 30-S cayear Treasury yields, respectively. As shown in the following chart, this has equated to a decline in long-term inflation expectations. Conclusion: demand for TIPn increase even as inflation fears subside.
Observation: the economy expanded at a 5% pace in the first half of this year, yet real yields experienced their first significant decline since TIPS were issued in 1997, as illustrated in the next chart. The widely-held belief that real yields must match real growth has great intuitive appeal, but little basis in fact. Conclusion: real yields are not necessarily determined by the pace of real growth.
Observation: expectations of Fed policy explain most of the action in the TIPS market. The Fed impacts the economy by targeting not just the overnight funds rate, but also the level of real short-term interest rates. For example, a decision to leave the funds rate target unchanged in the presence of falling inflation would be a decision to tighten monetary policy, since the Fed would be allowing real interest rates to rise.
Financial markets respond not only to the Fed's current target, but also attempt to anticipate the future direction of Fed policy. Expectations of the future level of real interest rates are best reflected in the eurodollar futures market, the blue line in the chart above.
When TIPS yields peaked early this year, the Fed was expected to mount an aggressive tightening campaign. With the economic data now reflecting a slowing in the pace of growth, the market believes the Fed has achieved its desired "soft landing" and will leave policy unchanged for the foreseeable future.
Conclusion: the pace of real growth can influence real yields to the extent that the Fed focuses on targeting growth. Real yields could decline further if the economy were to slow down enough to prompt an easing of Fed policy.
Meanwhile, budget surpluses increase the likelihood that TIPS issuance will be sharply curtailed over the next year or so. This could result in increased scarcity value for TIPS and lower real yields. Regardless, real yields in the neighborhood of 4% are still attractive from an historical perspective, and TIPS are still one of the best hedges against an unexpected rise in inflation.
This publication reflects current opinions of Western Asset Management and is for educational purposes only. Information contained herein, including data supplied by others, is believed to be accurate, but cannot be guaranteed. Opinions represented are neither a recommendation nor an offer of securities and statements in this material should not be considered investment advice. Employees and/or clients of Western Asset Management may have a position in the securities mentioned. This material may not be reproduced in any form without written permission.
Scott F. Grannis - Economist for Western Asset
August 2000
With the passage of time we continue to gain new insights into what drives the TIPS market. It's a complex interplay of forces that does not always produce the results that conventional wisdom would suggest.
Financial markets respond not only to the Fed's current target, but also attempt to anticipate the future direction of Fed policy. Expectations of the future level of real interest rates are best reflected in the eurodollar futures market, the blue line in the chart above.
When TIPS yields peaked early this year, the Fed was expected to mount an aggressive tightening campaign. With the economic data now reflecting a slowing in the pace of growth, the market believes the Fed has achieved its desired "soft landing" and will leave policy unchanged for the foreseeable future.
Conclusion: the pace of real growth can influence real yields to the extent that the Fed focuses on targeting growth. Real yields could decline further if the economy were to slow down enough to prompt an easing of Fed policy.
Meanwhile, budget surpluses increase the likelihood that TIPS issuance will be sharply curtailed over the next year or so. This could result in increased scarcity value for TIPS and lower real yields. Regardless, real yields in the neighborhood of 4% are still attractive from an historical perspective, and TIPS are still one of the best hedges against an unexpected rise in inflation.
This publication reflects current opinions of Western Asset Management and is for educational purposes only. Information contained herein, including data supplied by others, is believed to be accurate, but cannot be guaranteed. Opinions represented are neither a recommendation nor an offer of securities and statements in this material should not be considered investment advice. Employees and/or clients of Western Asset Management may have a position in the securities mentioned. This material may not be reproduced in any form without written permission.