Meanwhile, the TIPS market is pricing very high real interest rates (what the Fed actually needs to lower) and, together with nominal bonds, problematic deflation. Some of this is due to TIPS' recent illiquidity but a fair part of it is a real fear by investors that deflation is not only possible but in the near-term probable.
Also, the Fed's forecast inflation has slipped towards the lower end of its supposed target range. Question: is there any good reason the Fed should not consider targeting TIPS, rather than nominal bonds, for its quantitative easing purchases? The Fed could kill two birds with one stone by buying TIPS and stating that they would buy them until 10y BEI was at least 2% (for example). Indeed, the Fed could even say that it would sell those bonds when BEI got to, say, 3% or 4%, thus pre-announcing when the Q-E would be unwound and providing a de facto inflation target.
Because I am an inflation derivatives trader, people generally expect me to be a big bull on inflation. Certainly, some entire Wall Street firms are structured so as to encourage the expectation that inflation is going to surge so investors should buy TIPS! But my view tends to be more agnostic: inflation-linked assets are an important product regardless of where inflation is going in the next week, month, or year, because all investors are sitting by default in nominal space and are making an implied bet on inflation (that it will remain low); many of them should not be making that bet. I think of inflation protection as insurance against an unlikely outcome: people buy fire insurance on their homes all the time even though they aren't expecting them to burn down. But one inflationary debacle and your wealth just went up in smoke.
I entitled this comment provocatively, but my real point is that if we are inflation-indexed, the whole point is that we are immunized against inflation. We don't care which way it is going. We are trained to think of buying TIPS as being a bet on inflation, but in fact it's the other way around: holding nominal assets is the bet; to own TIPS is to be neutral on the matter.
The interbank inflation market is pricing tomorrow's CPI-U (for July) at 219.0 - 219.3 market.
But at a price of 101-00, the Jan 2009 TIPS imply a settlement index of only 218.16 for Jan 15, 2009 (which will be interpolated betwen the October and November CPI-U setitngs. There are at least two ways you can get to that number. Here is one of them:
I can earn 2.10% on an OIS basis to 1/15/09. Alternatively, I can buy the Jan-09 TIPS at 101-00, for a full price of 134.3964. To earn 2.10% annualized on an initial investment of 134.3964, I would have to end up with 134.3964 * (1 + 2.10% * 154/360) = 135.604.
I only have one cash flow left, constituting the coupon (1/2 of 3.875% rate) and the principal. That flow, in nominal dollars, will be $100 * [ 1+(3.875%/2) ] * EndCPI / 164.00000, where the last expression is the index adjustment. It is a simple matter then to show that, for this flow to equal 135.604 (and so for me to be indifferent), the EndCPI must be 218.16.
