Yesterday we took a look at precious metals and bitcoin…

Bitcoin is showing slight hints of the Tulip Mania from the 17th century… it will be interesting to see if things end the same way. Here’s something fun I put together… 

Tulips v Bitcoin Bubbles

Now if I wound the chart back a few more years for Bitcoin – we would smash the 60x. 

As I showed readers yesterday, in 2010 Bitcoin traded for just one quarter of one cent.

$1 invested in the currency seven years ago is worth a cool $750,000 today.

Or if you went completely crazy and bought $5 of the currency – that would be worth $4.4M today. 

That makes our Tulip Mania look like child’s play in comparison….

One thing is for sure – there is no “bubble” to speak of in terms of precious metals.

It’s the opposite.

In fact, these two old timers are meandering – caught in a tight range waiting for the next catalyst to move them notably higher (or lower).

The lesson?

Never force a trade.

From mine, the best trade in this environment is no trade at all. Step aside.

Let the market thrash around until we are presented with a better deal.

Not every deal we are handed in the market is a good one.

In fact, very few are. They take patience.

For example, I thought the deal offered from silver approx 4-weeks ago was a poor one. However, I also commented how the metal was attracting large capital inflows.

I asked the question: “were fund managers trying to forecast a turnaround be correct? Or will the tape prove them wrong”?

So far that trade has not worked out too well.

But that’s the thing… there are “thousands” of places to look for a more compelling trade. Currencies, bonds, stocks, ETFs… you name it.

As it stands today, there is nothing overwhelming with respect to precious metals.

Now one important thing I highlighted to readers was the (strong) relationship between gold and the real yields on the 5-Year Treasury Inflation Protected Securities (TIPS).

Today we will explore this further and explain why TIPS are central to any investor / trading who is trying to understand the market.

What are TIPS?

I appreciate that many readers of this blog are new to trading and/or investing.

As such, when we use a term like TIPS, it’s important we break it down for those who are less familiar.

Put simply – TIPS refer to a treasury security that is indexed to inflation in order to protect investors from the negative effects of inflation.

They are considered ultra-safe since they are backed by the U.S. government and because the par value rises with inflation, as measured by the Consumer Price Index, while the interest rate remains fixed.

If you are planning to invest in TIPS — they can be purchased directly from the U.S. government through their TreasuryDirect system in $100 increments with a minimum investment of $100.

Alternatively, investors can also get exposure through an exchange traded fund (ETF) – often more popular.

On the flip side – if you buy them directly – you will avoid the management fees associated with mutual funds.

TIPS are exceptionally liquid — with something like US$1.24 trillion of marketable TIPS outstanding — representing ~9% of outstanding marketable Treasury debt.

As such, their price (and yield) is something worth paying attention to.

Why Are They Important?

TIPS were not introduced until 1997.

They were introduced as investors desired market-based measure of real yields.

Prior to the launch of TIPS, real yields could only be observed ex post, by subtracting inflation from nominal yields.

With TIPS, we know today the risk-free real yields that investors expect to receive in the future.

As I say, this has been an important addition to investor’s portfolios.

Using the Federal Reserve’s own website — I have generated a chart which shows three key data series:

  • 5-Year TIPS (red)
  • 5-Year Forward Inflation Expectations (blue); and
  • 5-Year Treasury Yields (green)

As I was saying only yesterday – TIPS give us direct insight into the market’s inflation expectations.

Subtracting the real yield on 5-yr TIPS (red line) from the nominal yield on 5-yr Treasuries (green line) tells us the market’s implied inflation forecast, which today is 1.57%

That is, the market expects the CPI to average 1.57% over the next 5 years.

Below I have highlighted these values to better illustrate the calculation:

5-Year CPI Expectations: 1.76% – 0.19% = 1.57%

What’s important is the Fed’s target is around 2.0% (perhaps slightly higher).

However, what we also find is the current rate of inflation (and what we see from history) is nothing out of the ordinary.

Relationship with Crude

Now readers will often hear me talking about the importance of oil prices as they pertain to inflation.

In short, the lower we see crude, the lower the inflation read and vice versa.

Today crude prices are being belted due to (a) global over supply (not slowing down); and (b) moderate demand (growth) expectations (more on this shortly).

I don’t expect this to change anytime soon.

Below I have put together a chart which shows the strong correlation:

This is a very telling chart for one reason:

It clearly demonstrates the lower inflation is opposite crude and less about what the Fed are doing with monetary policy (despite misguided mainstream rhetoric).

5-Yr TIPS versus Real GDP Growth

The final chart I wanted to share is the 5-Year TIPS versus what we see with real U.S. GDP Growth:

As we have been highlighting in recent months — what’s clear is the market is not overly optimistic about the U.S. economy’s growth potential.

Real yields on 5-year TIPS have largely tracked the economy’s trend growth rate for well over a decade.

However, if we focus on the past 4 years – we see that real yields have traded in a narrow range (moving slightly higher from -4% in 2011) and real GDP growth has averaged slightly less than 2% over this same period.

As an aside, it’s worth noting that when real GDP averaged over 4% in the late 1990s — we also saw real yields on TIPS were just under 4%.

Today expectations are far lower…

Putting it All Together…

Repeating what I said yesterday – higher real yields on TIPS would be a good signal that the market is expecting stronger real growth in coming years.

And whilst things have improved notably since the lows of 2011 — there is plenty of work to do yet.

Keep your eye on these charts.

From mine, 5-year TIPS are an important data point when trying to gauge what the market feels about the economy’s growth prospects.

… trade the tape

When investing in shares, you can lose you some or all of your money. The potential gains on my blog are based on investing in Australian and US markets and don’t include taxes, brokerage commissions, or other fees. It’s important you seek independent financial advice regarding your particular situation. For any investment, never invest more than you can afford to lose, and keep in mind the ultimate risk is that you can lose whatever you’ve invested. If in doubt – always seek independent financial advice.

2 thoughts on “Why Real-Yields on TIPS are Critical”

  1. Really enjoying the recent posts that not only provide insights but also contain explanations/definitions etc. Really helpful to the novice (like myself).

    Do you get more free time these days to blog?

    Ps I recall maybe 18 months ago you were considering doing a subscription based trading service. I assume your plans changed due to work in Singapore?

    Keep up the great work with the blog 🙂

    1. Hey Angela

      It’s great you are enjoying the blog and my attempt(s) to explain some of the more important financial metrics.

      My view is economics and markets can be made simple – if explained the right way.

      Unfortunately so called “professionals” like to make these things more complex than they are (ie so they can charge you a fee to manage your money).

      Reality is they are not complex at all.

      Yes, 18 months ago I was considering launching a trading based subscription service.

      However, I decided to take the opportunity I have now (which is great fun). Therefore, I have shelved those plans for now. But I am sure it’s something I will launch one day.

      I don’t get much time these days to write (not as much as I would like). My work is pretty intense (and I travel a lot).

      Sometimes if I get an hour to myself at night I pen a few thoughts… but typically it’s weekends.

      Thanks for the kind words… I appreciate it.

      It’s great to know what readers are thinking reading the blog.

      For example, sometimes I can spend 2-3 hours on a post (getting the graphics right – choosing the right language) – and you don’t know if people are (a) reading it; or (b) getting any benefit from it? But it’s always nice to know that some people appreciate the time it takes.

      Irrespective, I enjoy it… and thanks again.

      cheers
      adrian

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