[ExI] M0 singularity... you're soaking in it

[Gordon Swobe]

--- On Tue, 2/3/09, samantha <sjatkins at mac.com> wrote:

>> As for inflation concerns, in response to the
>> financial crisis the spread between the yields on ten year
>> treasury bonds and TIPS (ten year treasury inflation
>> protected securities) dropped radically from more than 2% to
>> near 0%. This means investors in treasury bonds have stopped
>> demanding compensation for inflation risk. 
>  
> 
> I think the TIPS business is telling us that China and
> other countries who bought Treasuries heavily no longer
> believe they are worth much because they no longer have
> hardly any faith in the US economy or US long term solvency.
> The message is not low estimate of inflation I am afraid.

You imply that treasuries have lost market value. Actually they have gained value.

A quick primer:

Bond investors bear three kinds of risk:

1) Credit risk: 
When bond issuers default on interest or principal payments, investors lose money. Credit risk represents an important consideration when investing in corporate bonds, especially those issued by companies in poor financial condition.

2) Market risk: 
When interest rates go up, all bond values go down. Investors in high quality bonds including treasury bonds can feel confident about receiving their principal back at maturity, but they must nevertheless bear market risk until the maturity date. If interest rates have risen and if they must sell on the market before maturity, they'll likely incur a capital loss.

3) Inflation risk: 
After adjusting for inflation, bond investors can lose money in real terms even in high quality bonds held to maturity. This happens when the rate of inflation during the life of the investment exceeds the bond's nominal yield. For example if one invests in a bond yielding 3%, and inflation goes to 4%, one's real rate of return will equal minus 1%.

One can minimize credit risk by investing in US Treasury bonds, which have the backing of the full faith and credit (and taxing authority) of the US government. No investment on earth has less credit risk than US Treasuries.

One can simultaneously minimize both credit and inflation risk by investing in super-safe inflation-protected treasuries (TIPS). These US treasury-based securities not only have almost zero credit risk, and very little market risk, but they're also indexed to inflation. These investments don't pay much interest, but investors in these securities have little to worry about.

The difference between the yields on ordinary treasuries and TIPS represents the TIPS spread: the extra yield that investors in ordinary treasuries demand for bearing inflation risk. That extra yield represents a reasonable measure of the market's estimate of future inflation.

Last July the TIPS spread equaled about 2.5% for ten year bonds, corresponding to the Fed's target inflation rate. Healthy.

After the credit crisis unfolded last October, the ten year TIPS spread dropped to near 0%. Currently it hovers around .5%. Sick.

How do we explain this? I can think of two explanations:

Explanation A) 
The market expects negligible inflation and possible deflation for the next ten years.

Explanation B) 
Something else is also at work in the market for ordinary treasuries and TIPS. The inflated values of ordinary treasuries (and their freakishly low yields relative to TIPS) reflect not only reduced inflation expectations, but also increased expectations of corporate defaults and increased demand for the safety associated with the large and highly liquid market for ordinary treasuries. 

As I suggested in an earlier message, both explanations represent bad economic news. Both explanations point to a long-term economic slump. Both argue against long term inflation and for long term disinflation/deflation.

Explanation B) looks even worse than A). And the more I think about B), the more reasonable it seems. 

If the market is efficient then we should look to the market to help us forecast the economy. And this market indicator is flashing a warning signal about something much worse than a garden-variety recession.

-gts