Inefficient markets and inflation-linked bonds August 15, 2010 at 1:54 pm

There has been predictable hullabaloo about negative TIPs yields. The more balanced end of the spectrum is this from Reuters

Investors are betting that inflation rate will rise, fattening the return on the securities and making up for the negative yield.

Or this from Seeking Alpha:

Why is the real yield negative? There are two main reasons.

  1. Liquidity crisis – TIPS investors are afraid and looking for safety and liquidity at any price.
  2. Inflation Expectations – The 5-Year Treasury yield is now 2.43%, so the implied inflation rate priced into the 5-Year TIPS is about 2.61% annually. This is higher than the Fed’s target inflation rate. The TIPS market is saying that the Fed is under-estimating future CPI inflation.

What’s actually going on then?

The only thing we can really deduce is that there are a lot of buyers of TIPS. What we can’t easily deduce from the TIPS yield right now is forward US inflation. Why? Well first because the argument that allows us to derive inflation from TIPS yields depends on the financing cost of nominal treasuries and linkers being the same. Right now TIPS are scarce and you cannot repo them in as easily as nominal treasuries. (This is because of retail demand, plus linkers being asset swapped to provide inflation legs against inflation swaps to pension funds.) Second, TIPS have a zero floor, so you have to option adjust the bond, but figuring out the vol to use for the option isn’t easy as there are no linkers out there without the floor and the market in inflation options is thin to say the least. (With inflation at 3% and with low inflation vol, the floor was pretty much worthless so people used to ignore it. That is no longer true.)

The first point above, then, is probably true. But don’t get carried away in thinking that the TIPS yield tells you much about inflation expectations until you have at least figured out how to account for the liquidity premium, financing and OIS effects.

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