One More Nail In Inflation's Coffin?

Sagging indexed bonds show the market expects stable prices

When the Treasury Dept. staged its first auction of "inflation-indexed" bonds last January, the new instruments were hailed by Wall Street's grizzled veterans as the perfect hedge against a repeat of 1970s-style inflation. The rollout was also cheered by Federal Reserve policymakers, who were convinced that indexed bonds could give them new insights into the market's outlook on future inflation.

For investors, Treasury's Inflation Protection Securities (TIPS) have been a disappointment. Not only has the value of those bonds fallen below par, but the combined interest rate and inflation payment is far below the 6.7% year-to-date total return on the traditional government bond. But, as a barometer of future prices, TIPS are sending a powerful signal: The explosive drop in interest rates in recent months isn't based on fears of an economic slowdown, but reflects the market's growing belief that inflation simply isn't much of a long-term threat. "There's a definite lessening of inflation expectations," concludes Mickey D. Levy, chief economist for NationsBanc Capital Markets Inc.

TIPS SHEETS. Here's how this new crystal ball works: Economists track the difference--or spread--between yields on conventional and indexed bonds with the same maturities. Interest rates on indexed bonds are lower because holders receive a separate payment equal to the prevailing inflation rate (table). By contrast, conventional bonds offer no such hedge. Investors are willing to accept a lower rate on indexed bonds for the inflation protection. By subtracting the interest rate on indexed bonds from the return on conventional bonds, economists come up with the inflation rate that investors anticipate over the life of the five- and 10-year TIPS.

This spread should narrow when inflation fears recede. And indeed, that's just what has been happening in recent months: When the 10-year bonds were first offered in January, the government set the interest rate at 3.44%, vs. the 6.6.% for the non-indexed bond. So the inflation expectation at that time comes to 3.16%. Following a spate of favorable news on the inflation front, yields on 10-year Treasuries have fallen as low as 5.95%, while at the same time, the interest rate on 10-year indexed bonds has risen only slightly, to 3.53%. Thus, according to this new TIPS sheet, prices are expected to climb only 2.42% annually over the next decade (chart). What's more, indexed bonds issued in Britain, Australia, and Canada show the same pattern--declining inflation premiums.

Tracking these inflation expectations isn't just an academic exercise. Economists say this new indicator provides not only a good gauge of how the market perceives the risks of higher inflation, "but what the market thinks about current Fed policy," notes Brian S. Wesbury, chief economist for Griffin, Kubik, Stephens & Thompson Inc.

Despite the current bond rally, the "real," or inflation-adjusted, interest rates remain high. That, coupled with the drop in inflation expectations, may give the Fed more confidence to stand pat even in the face of steady growth. Interestingly, while Fed Chairman Alan Greenspan expressed his concerns to Congress on Oct. 8 about the near-term risk posed by tight labor markets--remarks that spooked the stock market--he also acknowledged that "inflation premiums, embodied in long-term interest rates, still are significant.... There is, thus, doubtless a lot of catching up to do." By this he meant that the inflation expectations built into the bond market are still too high. To some Fed watchers, the implication is that, despite his short-term concerns, the Fed chief thinks long-term interest rates could come down further over time.

To be sure, some economists--and even a few Fed officials--warn against treating the new indexed bonds as holy writ. Their argument: Trading in these complex securities remains relatively light, and economists don't yet have the benefit of looking across the full spectrum of maturities because the government has only issued 5- and 10-year bonds. "Considerable analysis must still be done before we can cull readings of inflation expectations and inflation risk from market prices," says Fed Governor Laurence H. Meyer.

But believers such as Levy say skeptics just don't want to admit they've misjudged the ongoing drop in inflation--and thus refuse to believe it can remain low. What's more, the dearth of demand for indexed bonds in itself may be a measure of how little investors fear that prices will accelerate out of control.

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