Friday, December 12, 2008

How negative are bond investors - look at the TIPS market

If you want to see how negative are bond investors about the economy, look at the TIPS market. Comparing the break-even spreads between nominal and inflation protected bonds, you will find the view that we should see deflation over the next few years. We may expect this for Japan, but this is unusual for the US. We are not seeing expected deflation in Europe or Canada where there are well-developed inflation protected markets.

Five year break-evens in the US market are at -18 bps. Similar break-evens exist for UK IPS. Clearly, the economic problems in the UK are similar in magnitude as the US. The French IPS which can be a proxy for the EU are showing positive inflation. Further out the yield curve the inflation numbers look positive but the US is at the low end of the range after accounting for Japan.

The break-even inflation rates are a relative price between nominal and inflation protected bonds so an alternative explanation could be the Treasury bubble story that is making the rounds. In that case, nominal bonds are being driven down in yield as the flight to quality continues. The overreaction to a flight to quality is pushing nominal bonds lower than where the should be. The only problem with this story is why wouldn't the market buy more of the Treasury IPS which have the full faith and credit of the US government.

The pessimism story for growth with deflation seems to be the driver with this group of investors.

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