TIPS & Inflation (expected vs. unexpected) ?

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ResearchMed
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TIPS & Inflation (expected vs. unexpected) ?

Post by ResearchMed » Fri Jul 31, 2020 3:27 pm

The discussion in another thread has re-triggered a question I've long had.
And apologies if this is simplistic and I "should already know" (which is how I feel, but...).

There is much discussion about expected vs unexpected inflation, and how TIPS are really for the latter.

So... just what is the difference?
Indeed, when does some factor in an inflation measure change from "expected" to "unexpected"?
Is it only qualitative? (X suddenly happens.) or could it also be something just quantitative, like, "the price of eggs suddenly quadrupled when they were expected to go up 5%"?

Many thanks.

RM
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Re: TIPS & Inflation (expected vs. unexpected) ?

Post by alex_686 » Fri Jul 31, 2020 3:37 pm

In theory, a 10 year bond should have the same expected yield as a 10 Year TIPS.

So if a 10 year Treasury is yielding 3%, and the TIPS is yielding 1%, the expected inflation is 2%.

That is, the market is determining the prices of these bonds thus we can infer what the market expects inflation to be.

There is a fair amount of nuance here. Maybe the market is not prefect but distorted. Maybe investors are willing to pay a higher price (i.e. lower yield) for the insurance like inflation optionality of a TIPS bond. etc.

As for unexpected - well... The Fed and economist publish predictions. There are more exotic instruments out there like inflation swaps. These actually do a pretty good job of estimating what inflation will be. They also come in ranges. You can also infer this stuff from market trading.

Figure out what is important and what your confidence interval is. Maybe a 90% confidence interval? Breach that and things are unexpected.
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Re: TIPS & Inflation (expected vs. unexpected) ?

Post by FIREchief » Fri Jul 31, 2020 7:08 pm

I think alex_686 explained it pretty well. The "inflation protection premium" that exists in theory is hard (actually impossible) to isolate and in recent years there is much evidence to suggest it has essentially been "free insurance." I will point out that some equate the term "unexpected inflation" with hyper-inflation (think 70's style double digit). It can certainly be that, but it is much more likely to be several years where actual inflation comes in 0.5% to 1.0% above the breakeven inflation rates at the time of a TIPS auction. That can really add up for a longer term TIPS.
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Re: TIPS & Inflation (expected vs. unexpected) ?

Post by dbr » Sat Aug 01, 2020 7:02 am

The theory is good and maybe helpful, but from a practical point of view TIPS are a bond that does not have inflation risk and other bonds do. That applies to all TIPS all the time and is not affected by dividing inflation between expected and unexpected.

I think sometimes investors get a little hung up on whether they will be better of with TIPS or with nominal and I don't think that has anything to do with deciding between the two. If you don't want inflation risk then get rid of it by holding TIPS.

That does give rise to the question why one would ever hold anything except TIPS, but that is another discussion.

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Re: TIPS & Inflation (expected vs. unexpected) ?

Post by vineviz » Sat Aug 01, 2020 7:14 am

ResearchMed wrote:
Fri Jul 31, 2020 3:27 pm

So... just what is the difference?
Indeed, when does some factor in an inflation measure change from "expected" to "unexpected"?
I'm sure you get what "expected inflation" means. "Unexpected inflation" is just the difference between realized (actual) inflation measured at the end of some period and the inflation that was expected at the beginning of that same period.

You're getting ready to drive to your office and when you start your car the GPS estimates the drive time will be 12 minutes. 12 minutes is the expected drive time. It turns out that you got stuck behind a very slow garbage truck and hit four red lights in a row, so the actual drive took 17 minutes.

17 minutes is the actual drive time, comprised of 12 minutes of expected driving and 5 minutes of unexpected driving.
Last edited by vineviz on Sat Aug 01, 2020 8:46 am, edited 1 time in total.
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Re: TIPS & Inflation (expected vs. unexpected) ?

Post by HappyJack » Sat Aug 01, 2020 8:43 am

Brilliant!

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Re: TIPS & Inflation (expected vs. unexpected) ?

Post by Doc » Sat Aug 01, 2020 8:57 am

Back at the beginning the storey was that TIPS were instituted by the Treasury so it could get a reading on what people expected inflation to be in the future. This idea didn't work because there was no way to measure the insurance premium or the liquidity cost associated with the the bond.

Some 20 plus years later the question remains unanswered. :D
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Re: TIPS & Inflation (expected vs. unexpected) ?

Post by Seasonal » Sat Aug 01, 2020 9:00 am

The spread between TIPS and nominal Treasuries is a function of expected inflation, a liquidity discount for TIPS (treasuries are more liquid) and an inflation insurance premium for TIPS (protecting against unexpected inflation). The liquidity discount and inflation insurance components may or may not cancel each other out, but the difference should not be large in this context.

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Re: TIPS & Inflation (expected vs. unexpected) ?

Post by Doc » Sat Aug 01, 2020 9:39 am

Seasonal wrote:
Sat Aug 01, 2020 9:00 am
The spread between TIPS and nominal Treasuries is a function of expected inflation, a liquidity discount for TIPS (treasuries are more liquid) and an inflation insurance premium for TIPS (protecting against unexpected inflation). The liquidity discount and inflation insurance components may or may not cancel each other out, but the difference should not be large in this context.
How do we know the size of the difference? Both are subject to change and that change does not have to have a high (negative) correlation.

The liquidity premium in 2008 was humongous.
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Re: TIPS & Inflation (expected vs. unexpected) ?

Post by Robot Monster » Sat Aug 01, 2020 11:03 am

vineviz wrote:
Sat Aug 01, 2020 7:14 am
ResearchMed wrote:
Fri Jul 31, 2020 3:27 pm

So... just what is the difference?
Indeed, when does some factor in an inflation measure change from "expected" to "unexpected"?
I'm sure you get what "expected inflation" means. "Unexpected inflation" is just the difference between realized (actual) inflation measured at the end of some period and the inflation that was expected at the beginning of that same period.

You're getting ready to drive to your office and when you start your car the GPS estimates the drive time will be 12 minutes. 12 minutes is the expected drive time. It turns out that you got stuck behind a very slow garbage truck and hit four red lights in a row, so the actual drive took 17 minutes.

17 minutes is the actual drive time, comprised of 12 minutes of expected driving and 5 minutes of unexpected driving.
Stealing from this excellent metaphor by vineziv, imagine this:

You've been put into a car race, of sorts. What you have to do is follow a red car from point A to point B. This red car symbolizes inflation. If you can get ahead of the car, that's great, but at the very least, try not to lag behind too much.

The problem is you've only got two vehicles in which to do this.

Vehicle 1 (the nominal bond vehicle): The speed of this vehicle is pre-set at the beginning of the trip to be very vaguely calibrated with the red car's expected speed from point A to point B. The red car's expected speed is 15 mph, while Vehicle 1 is pre-set to 10 mph; it will always go 10 mph no matter how fast the red car actually goes.

Vehicle 2 (the TIPS vehicle): The speed of this vehicle will always lag behind the red car by 5 mph.

If the red car goes faster than the expected speed (more inflation than expected), you're better off with TIPS, and if that little red car unexpectedly floors it (hyperinflation) you would certainly be much happier with TIPS than nominal!
Investors often exhibit a tendency to evaluate the performance of their portfolio over very short horizons (e.g. days) even when their actual investment time horizon is quite long (e.g. decades).

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Re: TIPS & Inflation (expected vs. unexpected) ?

Post by HappyJack » Sat Aug 01, 2020 11:19 am

:sharebeer

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Re: TIPS & Inflation (expected vs. unexpected) ?

Post by dodecahedron » Sat Aug 01, 2020 11:28 am

Doc wrote:
Sat Aug 01, 2020 8:57 am
Back at the beginning the storey was that TIPS were instituted by the Treasury so it could get a reading on what people expected inflation to be in the future.
I personally know some of the policymakers involved and think that is too strong a statement about the rationale for TIPS. TIPS were instituted for many reasons and possible information about expected future inflation was way down the list.

This 2004 NY Federal Reserve review article has a good discussion of the rationales for TIPS. The primary rationale was offering investors a new type of asset that would reduce risk, an idea long promoted in academic economic circles for decades prior to the materialization of TIPS. The article goes on to list several more rationales. Last but not least, the article mentions
In addition, some argued that issuing indexed debt would
offer ancillary benefits by providing policymakers and market
participants with a useful reading of real interest rates. In that
case, comparing the yields on TIIS with those on nominal
securities would provide a measure of the amount of
compensation that investors demand to offset future inflation
and the associated risks—a potentially useful gauge for
monetary policymakers.


So the original ¨some¨ who argued for ancillary benefits have been disappointed.

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Re: TIPS & Inflation (expected vs. unexpected) ?

Post by vineviz » Sat Aug 01, 2020 11:32 am

dodecahedron wrote:
Sat Aug 01, 2020 11:28 am


So the original ¨some¨ who argued for ancillary benefits have been disappointed.
I wouldn’t be so quick to assume that: the break even inflation rate is used by economists and policy makers alike as valuable information.

Not a perfect gauge If inflation expectations, to be sure, but useful nonetheless.
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Re: TIPS & Inflation (expected vs. unexpected) ?

Post by dodecahedron » Sat Aug 01, 2020 11:38 am

Robot Monster wrote:
Sat Aug 01, 2020 11:03 am
vineviz wrote:
Sat Aug 01, 2020 7:14 am
ResearchMed wrote:
Fri Jul 31, 2020 3:27 pm

So... just what is the difference?
Indeed, when does some factor in an inflation measure change from "expected" to "unexpected"?
I'm sure you get what "expected inflation" means. "Unexpected inflation" is just the difference between realized (actual) inflation measured at the end of some period and the inflation that was expected at the beginning of that same period.

You're getting ready to drive to your office and when you start your car the GPS estimates the drive time will be 12 minutes. 12 minutes is the expected drive time. It turns out that you got stuck behind a very slow garbage truck and hit four red lights in a row, so the actual drive took 17 minutes.

17 minutes is the actual drive time, comprised of 12 minutes of expected driving and 5 minutes of unexpected driving.
Stealing from this excellent metaphor by vineziv, imagine this:

You've been put into a car race, of sorts. What you have to do is follow a red car from point A to point B. This red car symbolizes inflation. If you can get ahead of the car, that's great, but at the very least, try not to lag behind too much.

The problem is you've only got two vehicles in which to do this.

Vehicle 1 (the nominal bond vehicle): The speed of this vehicle is pre-set at the beginning of the trip to be very vaguely calibrated with the red car's expected speed from point A to point B. The red car's expected speed is 15 mph, while Vehicle 1 is pre-set to 10 mph; it will always go 10 mph no matter how fast the red car actually goes.

Vehicle 2 (the TIPS vehicle): The speed of this vehicle will always lag behind the red car by 5 mph.

If the red car goes faster than the expected speed (more inflation than expected), you're better off with TIPS, and if that little red car unexpectedly floors it (hyperinflation) you would certainly be much happier with TIPS than nominal!
To build on this further, if the red car starts backing up significantly (hyperdeflation?) you will be much happier in Vehicle 1.

So putting some mix of your fixed income into both vehicles increases the likelihood that at least *some* of your portfolio will be within reasonable distance of the red car.

Reasonable people can differ about what the optimal mix of assets across those two vehicles should be, depending on factors like whether their liabilities are denominated in nominal or real terms, size of SS and COLA-indexed pensions, etc.

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Re: TIPS & Inflation (expected vs. unexpected) ?

Post by dodecahedron » Sat Aug 01, 2020 11:43 am

vineviz wrote:
Sat Aug 01, 2020 11:32 am
dodecahedron wrote:
Sat Aug 01, 2020 11:28 am


So the original ¨some¨ who argued for ancillary benefits have been disappointed.
I wouldn’t be so quick to assume that: the break even inflation rate is used by economists and policy makers alike as valuable information.

Not a perfect gauge If inflation expectations, to be sure, but useful nonetheless.
It is certainly interesting for academics and policy analysts to study, I will grant you that. Not sure if I can point to any concrete policy decisions informed by that information.

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Re: TIPS & Inflation (expected vs. unexpected) ?

Post by Doc » Sat Aug 01, 2020 12:31 pm

dodecahedron wrote:
Sat Aug 01, 2020 11:28 am
Doc wrote: ↑Sat Aug 01, 2020 8:57 am
Back at the beginning the storey was that TIPS were instituted by the Treasury so it could get a reading on what people expected inflation to be in the future.
I personally know some of the policymakers involved and think that is too strong a statement about the rationale for TIPS. TIPS were instituted for many reasons and possible information about expected future inflation was way down the list.

This 2004 NY Federal Reserve review article has a good discussion of the rationales for TIPS.
From page 2 of your reference: "In addition, some argued that issuing indexed debt would offer ancillary benefits by providing policymakers and market participants with a useful reading of real interest rates."

OK "some" doesn't necessarily mean people from the Treasury. My bad. :D

I don't know personally any of the policymakers involved but I do personally know some of the Bogleheads that concurred with the "usefuel reading of real interest rates". Actually the early TIPS discussion may have been not on Bogleheads but on the "Vanguard Diehards" forum on M*. (I'm showing my age.)

Personally since the 2008 era I have given up on TIPS completely. "TIPS are just like nominal Treasuries except for the inflation protection." NOT
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Re: TIPS & Inflation (expected vs. unexpected) ?

Post by FIREchief » Sat Aug 01, 2020 12:42 pm

Doc wrote:
Sat Aug 01, 2020 12:31 pm
"TIPS are just like nominal Treasuries except for the inflation protection." NOT
They are if you hold them to maturity.
I am not a lawyer, accountant or financial advisor. Any advice or suggestions that I may provide shall be considered for entertainment purposes only.

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Re: TIPS & Inflation (expected vs. unexpected) ?

Post by rlangford » Sat Aug 01, 2020 12:46 pm

deleted
Last edited by rlangford on Sat Aug 01, 2020 8:17 pm, edited 1 time in total.

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Re: TIPS & Inflation (expected vs. unexpected) ?

Post by Northern Flicker » Sat Aug 01, 2020 12:50 pm

ResearchMed wrote:
Fri Jul 31, 2020 3:27 pm
The discussion in another thread has re-triggered a question I've long had.
And apologies if this is simplistic and I "should already know" (which is how I feel, but...).

There is much discussion about expected vs unexpected inflation, and how TIPS are really for the latter.

So... just what is the difference?
Indeed, when does some factor in an inflation measure change from "expected" to "unexpected"?
Is it only qualitative? (X suddenly happens.) or could it also be something just quantitative, like, "the price of eggs suddenly quadrupled when they were expected to go up 5%"?

Many thanks.

RM
I think a more clear way of stating it is as follows.
TIPS protect you from all inflation. Nominal bonds protect you only from expected inflation.

But when real rates are negative like they are now, neither actually protect you fully from expected inflation. The low treasury rates have very little space for expected inflation or an inflation risk premium to fit. Expected inflation is higher than the treasury rates, leading to breakeven rates pushing TIPS yields well into negative territory.
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Re: TIPS & Inflation (expected vs. unexpected) ?

Post by dodecahedron » Sat Aug 01, 2020 12:52 pm

Doc wrote:
Sat Aug 01, 2020 12:31 pm
Personally since the 2008 era I have given up on TIPS completely. "TIPS are just like nominal Treasuries except for the inflation protection." NOT
I never liked nominal Treasuries. Direct purchase CDs seemed like a better deal for my temperament and circumstances and stage of life.

I gave up on TIPS for a while but when real interest rates on intermediate TIPS hit 1% in late 2018, I decided it was time to put at least *some* of my assets in vehicle 2. Yes, I realize real interest rates are now negative going forward, but quite okay with that given that my NAV has gone up quite a bit.

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Re: TIPS & Inflation (expected vs. unexpected) ?

Post by Doc » Sat Aug 01, 2020 12:59 pm

FIREchief wrote:
Sat Aug 01, 2020 12:42 pm
Doc wrote:
Sat Aug 01, 2020 12:31 pm
"TIPS are just like nominal Treasuries except for the inflation protection." NOT
They are if you hold them to maturity.
I don't hold Treasury notes to maturity.
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Re: TIPS & Inflation (expected vs. unexpected) ?

Post by FIREchief » Sat Aug 01, 2020 1:02 pm

Doc wrote:
Sat Aug 01, 2020 12:59 pm
FIREchief wrote:
Sat Aug 01, 2020 12:42 pm
Doc wrote:
Sat Aug 01, 2020 12:31 pm
"TIPS are just like nominal Treasuries except for the inflation protection." NOT
They are if you hold them to maturity.
I don't hold Treasury notes to maturity.
Yep, so for you and folks like you, they aren't just like nominal treasuries. For others, they are. 8-)
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Re: TIPS & Inflation (expected vs. unexpected) ?

Post by Doc » Sat Aug 01, 2020 1:03 pm

dodecahedron wrote:
Sat Aug 01, 2020 12:52 pm
Doc wrote:
Sat Aug 01, 2020 12:31 pm
Personally since the 2008 era I have given up on TIPS completely. "TIPS are just like nominal Treasuries except for the inflation protection." NOT
I never liked nominal Treasuries. Direct purchase CDs seemed like a better deal for my temperament and circumstances and stage of life.

I gave up on TIPS for a while but when real interest rates on intermediate TIPS hit 1% in late 2018, I decided it was time to put at least *some* of my assets in vehicle 2. Yes, I realize real interest rates are now negative going forward, but quite okay with that given that my NAV has gone up quite a bit.
I don't think that CD's don't give you the same "roll down yield" bonus that Treasuries can when sold before maturity.
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Re: TIPS & Inflation (expected vs. unexpected) ?

Post by dodecahedron » Sat Aug 01, 2020 1:22 pm

Doc wrote:
Sat Aug 01, 2020 1:03 pm
dodecahedron wrote:
Sat Aug 01, 2020 12:52 pm
Doc wrote:
Sat Aug 01, 2020 12:31 pm
Personally since the 2008 era I have given up on TIPS completely. "TIPS are just like nominal Treasuries except for the inflation protection." NOT
I never liked nominal Treasuries. Direct purchase CDs seemed like a better deal for my temperament and circumstances and stage of life.

I gave up on TIPS for a while but when real interest rates on intermediate TIPS hit 1% in late 2018, I decided it was time to put at least *some* of my assets in vehicle 2. Yes, I realize real interest rates are now negative going forward, but quite okay with that given that my NAV has gone up quite a bit.
I don't think that CD's don't give you the same "roll down yield" bonus that Treasuries can when sold before maturity.
At this stage of my life, and with all sorts of weird things in recent years like inverted yield curves, I am not interested in roll down yield. (Also, not going crazy chasing the highest CD rate at some out-of-the-way bank that requires lots of phone conversations and worrying about whether the assets will be transferred there in time to get the rate currently on offer.)

Life is too short to be stressing about second order stuff like that. Simplicity and focusing on big priorities is my guiding principle. Future inflation is a concern. So is future deflation. A mix of both types of fixed income investments (nominal and inflation protected) is good enough for me. To continue with the analogy, I am not interested in driving a fancy (high performance but tricky to maintain) sports car. Also not interested in driving on the Autobahn, so my percentage of equities is quite modest.

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Re: TIPS & Inflation (expected vs. unexpected) ?

Post by Doc » Sat Aug 01, 2020 1:33 pm

dodecahedron wrote:
Sat Aug 01, 2020 1:22 pm
At this stage of my life, and with all sorts of weird things in recent years like inverted yield curves, I am not interested in roll down yield
At this stage in my life, and with all sorts of weird things in recent months like inverted curves, I am still interested in roll down yield.

That said, my Treasuries are currently 90% in T-Bills while waiting for the yield curve to normalize so I can re-establish my 3-7 yr ladder.
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Re: TIPS & Inflation (expected vs. unexpected) ?

Post by Seasonal » Sat Aug 01, 2020 2:42 pm

Doc wrote:
Sat Aug 01, 2020 9:39 am
Seasonal wrote:
Sat Aug 01, 2020 9:00 am
The spread between TIPS and nominal Treasuries is a function of expected inflation, a liquidity discount for TIPS (treasuries are more liquid) and an inflation insurance premium for TIPS (protecting against unexpected inflation). The liquidity discount and inflation insurance components may or may not cancel each other out, but the difference should not be large in this context.
How do we know the size of the difference? Both are subject to change and that change does not have to have a high (negative) correlation.

The liquidity premium in 2008 was humongous.
We don't know for certain any of these magnitudes. Given estimates and the likely error bands around those estimates, it's unlikely the difference is all that meaningful.

Lots of things get out of whack during moments of extreme market dislocation. Fortunately, they seldom last very long.

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Re: TIPS & Inflation (expected vs. unexpected) ?

Post by Doc » Sat Aug 01, 2020 5:02 pm

Seasonal wrote:
Sat Aug 01, 2020 2:42 pm
We don't know for certain any of these magnitudes. Given estimates and the likely error bands around those estimates, it's unlikely the difference is all that meaningful.

Lots of things get out of whack during moments of extreme market dislocation. Fortunately, they seldom last very long.
Image

Here's the out of whack chart for '08. My entire ten year TIPS ladder got sold to rebalance in '08 because TIPS are NOT just like nominal Treasuries except for the inflation protection.
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Re: TIPS & Inflation (expected vs. unexpected) ?

Post by vineviz » Sat Aug 01, 2020 8:10 pm

Doc wrote:
Sat Aug 01, 2020 5:02 pm
Seasonal wrote:
Sat Aug 01, 2020 2:42 pm
We don't know for certain any of these magnitudes. Given estimates and the likely error bands around those estimates, it's unlikely the difference is all that meaningful.

Lots of things get out of whack during moments of extreme market dislocation. Fortunately, they seldom last very long.
Image

Here's the out of whack chart for '08. My entire ten year TIPS ladder got sold to rebalance in '08 because TIPS are NOT just like nominal Treasuries except for the inflation protection.
I’m sure you were frustrated, but that chart demonstrates the opposite of your claim: the inflation protection is what makes those lines diverge.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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