“YEAH, I’LL GIVE YA A TIP: DON’T PLAY THE HORSES”

Those of you who read the Pontificator frequently and carefully know that I have been long TIPS, GLD, and SLV for a long time. There are also a handful of people whom I advise with varying degrees of closeness on their portfolios and they have put money into all three instruments, but mostly into TIPS. I sent them the following missive today in response to inquiries about the future of TIPS. I thought my readers might find it interesting and a welcome break from the discussions of politics that have dominated the Pontificator over the last few weeks.


11/4/10

TIPS have run far and fast; the ETF TIP is up 8.4% YTD, excluding dividends, while the Vanguard Inflation Protected Bond Fund has delivered a 10.02% total return as of last night’s close. In fact, TIPS have run so far that the five year TIP is currently trading at a negative yield of 65 basis points. Several of you have asked what I am currently thinking about TIPS and what I am doing with my very large (for me) position in these instruments.

While a negative yield on the five year TIP is indeed eye-opening, the number to look at is not the absolute TIP yield, but the inflation rate implied by the spread between conventional treasuries and their corresponding TIPS. The implied inflation rate for the five, ten, and thirty year TIPS are currently 1.67%, 2.15%, and 2.68% respectively. When deciding whether to hold, or buy, TIPS, the question you have to ask yourself is whether you think that the inflation rate will come in below or above the aforementioned levels. If you believe that the inflation rate will be below 2.15% over the next ten years, you should hold conventional treasuries. If you think the inflation rate will be above 2.15% over the next ten years, you should hold TIPS. WITH A FED SEEMINGLY BENT ON INFLATING THIS NATION OF UP TO THE EYEBALLS BORROWERS OUT OF THEIR DEBTS, I AM CONFIDENT THAT WE WILL SEE INFLATION RATES FAR IN EXCESS OF THE 1.67%-2.68% RANGE IN THE COMING YEARS, SO I AM HANGING ONTO MY TIPS. Furthermore, conventional treasuries have outperformed TIPS so far this year, meaning that the implied inflation rates have gone DOWN year to date as the treasury markets have bought the “inflation is dead and buried, what we really have to worry about is deflation” drivel. This only enhances the attractiveness of TIPS for those of us who are not at all sanguine about inflation in an era when the Fed seems to be under the control of the monetary equivalent of the Nutty Professor.

Of course, if real rates (nominal interest rates less inflation) were to spike upward, one wouldn’t want to be in TIPS or any fixed income instruments beyond the shortest of maturities. While a spike in real rates is indeed possible, a spike in inflation, in my opinion, is far more likely to take place and to overwhelm any increase in real rates. By holding TIPS, we are protecting ourselves, at least to some extent, from such a bout of inflation.

I am also holding onto my positions in GLD and SLV (the gold and silver ETFs) for reasons remarkably similar to those that prompt me to hold onto my TIPS. GLD is up 25.7% year to date while SLV is up 51.4%. These gains, along with my gains in TIPS, have somehow taken the sting out of my largely missing out on the stock market rally (The S&P 500 and NASDAQ are up 8.8% and 10.5% year to date respectively.) in which the nation is currently basking.