TIPS market says, "Forget about inflation in 2014!"

12/16/2013 3:37 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

After rallying in September and October in anticipation of rising inflation in 2014, TIPS (Treasury Inflation Protected Securities) have dropped like a stone in the last month. They’re now down 8.8% in 2013, the biggest drop, according to Bank of America Merrill Lynch, since they were introduced in 1997.

According to the TIPS market forget about inflation in 2014. It’s a slowdown in price increases—which isn’t the same thing as deflation by a long shot—that faces the financial markets and the economy next year.

The gap in yields between fixed-rate Treasuries—where the payout doesn’t change with inflation—and TIPS—where the bond pays out more as inflation rises—shows the market predicting that inflation, by official measures, will average 1.75% over the next five years. That’s a huge decline from the year’s high in March when the TIPS market was pricing in a 2.42% inflation rate. (Economists surveyed in Bloomberg are expecting consumer price inflation of 1.5% this year. That would be the lowest rate since 2009 and the second-lowest annual rate since 1963.)

This view on inflation is a huge turnaround from the earlier consensus that the massive expansion of the Federal Reserve balance sheet would result in an increase of inflation as the increase in the money supply fed into the economy. The Fed’s balance sheet has climbed to almost $4 trillion from $900 billion in 2008 as the U.S. central bank bought financial assets to lower interest rates and stimulate the economy. (Similar increases in balance sheets and money supply by the European Central Bank and the Bank of Japan would result in global inflation, the consensus held.)

By it now looks like a decline in wages and employment and the associated weakness in demand will trump central bank printing presses. At least for a whie.

Now the TIPS market doesn’t have to be right. The current read on sub-2% inflation until the cows come home could be wrong—and this drop in TIPS could be a great buying opportunity ahead of a pick up in inflation in 2014 or 2015.

But, if the TIPS market is right, the financial markets are looking at low interest rates not until mid-2015, as the futures market is currently projecting, for even longer. That would come with very slow growth in top line sales for most companies and real pressure on earning. It would mean that companies would continue to borrow at low rates in order to fund buybacks that compensate for slower than expected organic earnings growth. It would mean cheap capital for companies that can identify actual investment opportunities with positive demand profiles—even as the number of those investment opportunities is likely to be relatively small. It would mean that while short-term bonds, where yields are already near 0%, wouldn’t deliver much in capital gains, longer maturity bonds might well outperform current expectations if low inflation leads to declining five- to 10-year yields. (That would mean that the U.S. government debt would be less of a burden for the next few years than many of us have feared.)

If the TIPS market is right, in other words, some major current trends will run longer than is currently expected, and some current expectations are due for a major upset.

Related Articles on STOCKS