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Inflation or deflation: 5 yr TIPs go negative

From today's Financial Times Even Bondholders Have Deflation Doubts (excerpted below):

But something weird happened this week in Treasury inflation-protected securities, or Tips, US inflation-linked government bonds. For only the second time in history, the five-year Tips offered a negative real yield; that is, buyers get back less than inflation.

Why would anyone want to buy an inflation-protected bond that is guaranteed not to protect fully against inflation? Perhaps if inflation were expected to be very high, prompting a rush for even partial protection. But that is hardly the case today. Rather, it is because Tips investors expect inflation to be higher than nominal bond yields: only by one hundredth of a percentage point, but enough to make it worth buying Tips with a definite real loss rather than straightforward bonds.

The substance of this phenomena is worth thinking about. Seems to us this analysis is just about right, although risk preference may come in to the calculation as well.  Deflation, of course,  brings a whole new meaning: "I would gladly pay you less on Tuesday for a hamburger today." 

What to do? We think not much and certainly nothing rash. The key is the longer term strategy. Those, including ourselves, who have genetic disposition to chronic fear of inflation, would do well to consider the substance of the market view that any pick up in aggregate demand may not eventuate in the near to intermediate term...or even later. The bond vigilantes counter argue that the only actionable solution is to monetize the debt by inflation (check the CBO report below).  Certainly, in the context of fixed income portfolios, the quest for real value will chafe against the avoidance of risk (do no harm), and the uncertainty in the markets once again suggests that the basics of diversification and risk management are essential.

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