As the Federal Reserve adjusts its ongoing monetary policy, their main concern is striking the necessary balance to control inflation and prevent deflation. In an effort to keep this post succinct and non JakeGint-esque I’ll try to present my research like a jujifruit- short, sweet, and bound to stick in your head for a while.

The TIP or Treasury Inflation Protected Security is an inflation indexed bond offered in the same maturity as its derivative. I decided to research whether the TIP yield could be used to determine the future state of monetary contraction or expansion. You would think if traders and PIMP(CO)s were worried about inflation that the TIPS yield would fall faster and lower than its parent or remain low and T-Bond yields rise faster. I took data directly from the Federal Reserve website and created the following charts.

This first chart contains the yields for the maturities listed in the legend. From 2001 to 2002 the yield curve steepens across the board and the inversion marked the peak in equities and impending recession. From then until 2006 the yield curve steepens and then flattens again. The really interesting part is where the TIPS yields blew the fuck out from Feb ‘08 to Oct ‘08 as bond traders carpet bombed the TIPS and pulled out their purses and bought the normal T-Bonds, in a very high pitched chirping Bill “Lip Gloss” Gross manner. This was the “oh shit not inflation, but deflation” reverse. The funny thing is that the trade was just a spike. The key part to remember here is that when TIPS yields blow out (as they did just prior to the flight to T-Bonds), expect a major deflationary event. After that, TIPS yields dropped sharply and now remain low, i.e. Ben pulled out and is back to playing “just the tip” with our economy.

For the second chart I calculated the spread between the TIPS yield and normal T-Bond yield for each maturity. When the lines go down the yield spread between the TIPS and T-Bond contract. This means deflation is perceived to be on the way. As the spread rises, TIPS are being bought or held on a relative basis more than T-Bonds are being sold or held, respectively. So right now it would seem like inflation is being perceived on the 5, 7, and 10 yr maturities. What about the 20? It seems like an outlier. Could the TIP/T-Bond market be pricing in only near term inflation?

One last comment and thought that seems interesting is that when the 20yr spread crosses over the 5yr spread, the short term maturity spreads reverse.