Sunday, June 21, 2009

Inflation Forecasts: Can We Really Predict the Future?

1.  Is the Break-even Spread for the TIP an Accurate Inflation Forecast by the World's Bond Gurus: I have repeatedly read comments by economist and assorted financial gurus that the break-even spread for the TIP is the market's inflation forecast for the future.  The break-even is currently at around 1.9% for a ten year TIP. In arguing that inflation is not expected to be a problem in the upcoming years, Alan Blinder makes this typical statement about the break-even spread:  

"The market's implied forecast of future inflation is indicated by the difference between the nominal interest rates on regular Treasury debt and the corresponding real interest rate on Treasury Inflation Protected Securities, or TIPS". NYT 

Blinder then adds that the break-even spread on the five year TIP is 1.6% and 1.9% on the 10 year, which he views as the equivalent of the market's expected inflation rate for those periods. 

Or, put another way, the yield on the TIP is deemed to be the real interest rate (Real interest rate - Wikipedia) and the difference between that rate and the nominal rate is the predicted rate of inflation. (real interest rate=nominal interest rate -inflation rate)(more precise:  Fisher equation - Wikipedia)

In an interview in this week's Barron's, Paul McCulley also makes the case for low inflation.

Blinder  assumes that the market is prescient. He assumes that the market is correctly pricing the breakeven correctly now, and incorrectly priced it at near zero in January due to fears of financial Armageddon. Actually, the pricing was at the near zero level starting last October, so the market got it wrong for several months according to Blinder. Maybe, or maybe the market got it wrong in January and now, not only on the breakeven point but the nominal yield rate. Why assume the market had in wrong in January and has it right now?

After all, we are talking about predicting the future. If we put 100 smart people in a room, all trained in the dismal science like Blinder, Greenspan and Bernanke and another 100 of the smartest bond wizards, could that combination make an accurate forecast for the rate of inflation over the next ten years? Does the group acquire a crystal ball that the individual does not have because of its larger number and superior intellect and education? That is an absurd concept for me to accept. In the last analysis the future is not knowable. Maybe we all need to say that a few trillion times, write it on the blackboard until it starts to sink in a little. 

In the last analysis, when evaluating the TIP now as an investor, it simply makes more sense to me to view the breakeven as the price for insurance or as a hedge against unexpected inflation, that is, inflation running at greater than 1.9% over the next ten years. A purchase of the 10 year TIP now would make sense only if I believed inflation would run at a greater pace than a 1.9% average over the next ten years.  

2.  So What Do I Do about Inflation Possibilities: While I recognize that the current slack worldwide demand, excess capacity, and unemployment are factors that will militate against a surge in inflation, I also have to recognize that the forecasters may be currently underestimating the timing and strength of an economic recovery, which would remove those restraints on inflation. Then, I do not recall anything remotely similar to the worldwide monetary and fiscal stimulus being done now.  I seriously doubt that Blinder, Bernanke or any other mortal for that matter can tell me what will happen as a result of those kind of unprecedented actions. While I do not question that those actions were necessary to avert a depression, I also see them as potentially inflationary. Do I know what will happen? No, of course not, neither does Blinder, Bernanke or anyone else either. So, for me, I view it as prudent to plan now for a potential unexpected rate of inflation later.  That is one reason that I have started buying again the TIP ETF during the 4th quarter of 2008, and the floating rate securities late last year and earlier this year when the pricing was extremely favorable, which has since largely disappeared. There are maybe two or three floating rate securities that I would buy at current prices. Floaters: Links in One Post I do not want to pay too dearly for the inflation protection, since I do not know about the future either. 

I am currently operating under what I would call a range forecast of inflation for the next ten years. This is what I would classify as the most reasonable range of numbers for an average based on what I know now, and given my extreme limitations as a lone wolf investor with no background in economics. I have to act based on my judgement and my judgement is currently an average inflation rate of 2 to 3%  over the next ten years, with 3 to 4% being more likely than 1 to 2%. So when I am making an investment today, I will evaluate a floater tied to the CPI with a 2 1/2% ten year average inflation forecast. I expect it to be lower than 2 1/2% over the next year and higher than 3% for two or more years, and that is about all that I can say. If I buy a CPI floater now with those assumptions, and it turns our that inflation comes in at 3.5%, then I will earn more than I expected in interest. 

 As I have stated in several earlier posts, whatever I am paid in interest for some of these bonds is almost a bonus to the hoped for return of just being paid par value at maturity of the bond. Both OSM or ISM, for example, are  selling at 50% discounts to par value as of last Friday's close, and both mature  in less than 10 years (OSM in 3/2017 and ISM in 1/2018). That is why I view the survival of SLM to be a more important consideration to me than the rate of inflation now or over the next ten years. If I get paid par value in 2017, I would be very pleased, and all of the monthly interest payments would then be just gravy. So when I did a computation on my recent OSM buy, I assumed an average of 2 1/2% inflation rate, and then did a computation based on that expectation (item #3: Late Afternoon Buys and Sells 6 9 2009)

Based on my last purchase at $11.8, the average current yield over the remaining seven years & nine months with that average inflation rate assumption would be 9.53%. I look at that number as sort of benchmark best guess now, it could end up being lower or higher than that from now until March 2017 as an average. It will certainly being much lower than the benchmark guess over the next year or so.   

I have stated in several posts that my main concern about OSM is its survival, not the rate of inflation and the recent comments by Cramer have temporarily lifted that concern somewhat. Cramer & Sallie Mae

Similar positive comments about SLM were made in Fleming Meeks' column at page M5 in this week's Barron's. Part of the more upbeat story on SLM has to do with winning the contract, along with three other firms, to service the government's student loan portfolio There is another contract that may be announced for originating those loans, which could give SLM another boost. So a security like OSM carries a lot of credit risk, unlike a TIP maturing in March 2017. But, then again, with increased risk comes the chance of increased return for those intrepid souls willing and able to assume the enhanced risk, for I know one thing for certain. A TIP maturing in 8 years is not going to go up in value 100% in addition to the current interest payments, and the TIP is not likely to pay me the same interest rate as a corporate bond floater. 

The main point is that I can not be anywhere near certain now about the rate of future inflation. I do not know and neither does anyone else. What is your prediction for the average inflation rate in the years 2014 and 2015? How about 1% or 5% or 2.4% or more than 5%?  Just pick a number and you may have a better chance at being right than the market's consensus forecast now. The fact that I do not know does not prevent me from planning now for a troublesome rate of inflation down the road, whatever it may turn out to be.  

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