-- Christopher Swann is a Reuters columnist. The views expressed are his own --
By Christopher Swann
NEW YORK, June 1 (Reuters) - Partisans often forget inconvenient evidence. But the collective amnesia of those fretting publicly about inflation is particularly striking. In fact it is relatively easy to test the hypothesis that the terror of inflation is driving up the cost of borrowing in financial markets. The picture that emerges from Treasury Inflation Protected Securities -- or TIPS -- is reassuring for everyone except opponents of the economic rescue plan. There are plenty of gauges of price expectations. Generally they rely on surveys of consumers or economists.
TIPS are the only one where the participants put their money where their mouth is. It is also by far the most timely. While TIPS can be viewed in real time, other measures become available only monthly or even quarterly. TIPS started life a little more than 10 years ago as an investment for timorous investors and are perhaps the closest thing there is to a risk-free investment.
They are also beloved of Fed officials who view them as an indispensible barometer of price expectations. (This is certainly the impression given by the president of the Federal Reserve Bank of New York, William Dudley, who delivered an encomium to the securities in December 2007, when he was executive vice president.) Reading inflation expectations from TIPS is an art rather than a science but it is a long way from tea leaves.
The key is to look for the breakeven inflation rate -- the level of price rises at which investors would be equally remunerated for holding TIPS or Treasuries.
Say conventional Treasuries are yielding 3.5 percent and TIPS are offering 1.5 percent, the TIPS investor can crack open the champagne if prices end up rising by more than 2 percent. If prices rise by less than this breakeven point, they can reach for the handkerchief. At the moment TIPS are sending a very clear message.
Investors are not pricing in hyper inflation and are not even pricing in high inflation over the next 10 years. The breakeven point for TIPS over a year is still negative at around 0.5 percent. At the five-year horizon it is 1 percent and at 10 years, 1.84 percent. Here is where the art comes in. The breakeven point for TIPS typically understates inflation expectations because investors demand a yield premium for holding a less liquid asset.
TIPS are not as plentiful as conventional Treasuries. At times when liquidity is a priority for investors this can make TIPS a wildly inaccurate guide to inflation fears.
In December, as market fears surged, TIPS appeared to be bracing for a deflation rate of 7 percent -- a forecast that even the Dr. Dooms in the market may have considered excessive.
In the current calmer markets, however, TIPS are once again much more reliable.
Nor are they as illiquid as some detractors would suggest. They may be just under 10 percent of total marketable Treasury securities, but this is still $529.3 billion. In the universe of global bonds, they are still among the most liquid in the world, according to Michael Pond, an analyst with Barclays Capital.
Add in a modest liquidity premium and TIPS are still only bracing for an inflation rate of just over 2 percent over 10 years. TIPS detractors will also argue that the purity of the market has been sullied by Treasury purchases by the Federal Reserve. In fact, the New York Fed has bought only $3 billion of TIPS so far -- out of total shopping basket of $130 billion and not enough to noticeably distort the market. There is still plenty enough bad news around without the need to make it up. So investors and policy makers should take solace in TIPS.
(Edited by David Evans)