TIPS auction with negative yields...

[craigr]

http://www.bloomberg.com/news/2010-10-2 ... -sale.html

The Treasury sold $10 billion of five-year Treasury Inflation Protected Securities at a negative yield for the first time at a U.S. debt auction as investors bet the Federal Reserve will be successful in halting deflation.

This kind of behavior is why I don't think TIPS are a suitable replacement for gold in the permanent portfolio. I think that TIPS are going to redline under bad inflation and not provide the real purchasing power protection of gold that a diversified portfolio needs.

[Lone Wolf]

Holy cow.  It's one thing to know that it's possible but quite another to see it happen (and to consider what it implies.)

If the market starts predicting accelerating inflation, couldn't the yields go very, very negative for an extended period of time?  If nominal treasuries are paying out 1-2% and for whatever reason the market starts "expecting" 10%+ inflation, what kind of TIPS yields am I going to be getting?  There's no real upper bound on an inflation rate, so I could see the market concluding that it's worth paying quite a premium for this protection.  But who knows?

While you'd be unlikely to get "totally screwed" by TIPS in the end, it's hard to imagine your investment "going to the moon" the way gold can (a mirror image of gold's infamous ability to crater in times of stability.)

While this kind of thing doesn't "ruin" TIPS for other purposes, it highlights why TIPS just can't substitute for gold in the PP.  It implies (to me at least) that you simply couldn't count on TIPS to shoulder the burden for an entire 75% of the portfolio that might be suffering through a high-inflation environment.  Gold is the only asset I know of capable of that kind of heavy lifting.  I wonder how TIPS would have performed even in a 70s-style "pretty bad" inflation environment.  And an environment like Argentina?  That can't be pretty.

[6 Iron]

They paid 550 basis points for 5 years TIPS according to the Times. I am paraphrasing HB, but this makes me think of his statement that while anything can happen, nothing has to happen (with regard to inflation). Boy, do I like not having to worry about this.

[MediumTex]

I hate that the BH PP discussion seems unable to resist wandering into the "TIPS for gold in the PP" idea.

TIPS are so obviously unsuitable for the PP that I know many of the people advocating them simply don't "get" the overall PP strategy or line of thinking.

That's actually good news, though, because perhaps when they "get" the concept and strategy behind the PP (i.e., putting non-correlated volatile assets in one package) they will see how silly TIPS are when considered as a stand-in for gold in a PP.

There is a place for TIPS in many portfolios, just not the PP.

[Lone Wolf]

Something else that's horrible about TIPS in the PP just occurred to me.  Since their tax treatment royally sucks you'd need to stick them in your tax-deferred space, while gold doesn't need any tax-deferral at all (although MT's idea of using one rebalance band's worth is a nice-to-have if you've got the space.)  Anyone who's had their tax-deferred space run dry in their PP knows that you need more pressure on your tax-deferral area(s) like you need another hole in the head.

So there you'd be, stuck with an instrument that with these yields will slightly lag the CPI (which I think will tend to somewhat understate inflation for the "man on the street".)  And there it is, sucking up all your tax-deferred space, mocking you.  And I can't even imagine these poor things trying to carry the other floundering 75% of the portfolio.  I mean, am I overselling the problems here?  It seems pretty bad to me.

Like 6 Iron said, it's nice to be looking at this as an outside observer.  But from where I sit, it seems like as uncertainty increases (and gold really finds its strength), don't these problems only get worse?  As the possibility of greater and greater inflation looms, wouldn't yields grow more and more negative?

I should also mention that the problems I'm listing are fairly specific to the PP.  I'm not really a TIPS hater.  I think even someone who was doing the Panicky Retiree Portfolio (PRP) of 100% TIPS is probably more or less going to be fine (whereas I'd call a 100% gold allocation "not fine"!)

[smurff]

So there you'd be, stuck with an instrument that with these yields will slightly lag the CPI (which I think will tend to somewhat understate inflation for the "man on the street".)  And there it is, sucking up all your tax-deferred space, mocking you.  And I can't even imagine these poor things trying to carry the other floundering 75% of the portfolio.  I mean, am I overselling the problems here?  It seems pretty bad to me.

I agree with Lone Wolf. 

Another issue with using TIPS to substitute for gold has to do with how inflation is defined and how the CPI is calculated.  The CPI (Consumer Price Index) is used as a stand-in for inflation, but it is not the same as inflation.  But that's a discussion for another thread.

Back in the early 1990s there was a radical change in methodology for calculating the CPI, in response to the budget deficit, among other things.  Basically, the CPI went from being a measure of price changes in a fixed basket of consumer goods, to being a measure of price SUBSTITUTIONS in an ever changing basket of consumer goods.  Under the original calculation, if the price of beef went up, this was reflected directly in the CPI.  Under the current calculation, if the price of beef goes up, the algorithm that calculates the CPI has built into it an assumption that rational consumers would substitute chicken, fish, or some other cheaper meat for beef.  The algorithm continues this substitution ad infinitum.  If a three-bedroom home is too expensive, the consumer moves into a two bedroom home; if new cars are expensive the consumer buys used; if the price of gas goes up, consumers ride the bus. The immediate effect of this change was that the index went down substantially, so much so that in some years it seems to indicate that there is no inflation at all.

Which brings us to the other effect:  The new CPI does not match everyday experience for lots of consumers (Lone Wolf's "man on the street"), especially those on fixed incomes or those having to deal with mandatory wage freezes at work.  It's hard to believe that the CPI is running along at a mere 1.2% when the price of Froot Loops has gone from about $3.50 a box to $4.99.  (Or even worse, when the 1 ounce, 25 cents bag of Cheetos has been transformed into a 0.75 ounce, 33 cents bag--along with a proliferation of bag sizes and differential prices on the same bag size to keep the consumer confused.)

Several economists have been calculating the "old" CPI to keep up with "real" inflation.  You can find an example at Shadowstats.com, which is run by the economist Walter J. Williams.  He has several free articles on his site; in one of them he points out that if the methodology for calculating the CPI had remained the same since the early 1990s, then employees, retirees, and others with COLA clauses in their contracts (or a COLA in the law that governs their benefits, like the amended Social Security Act) would be paid twice as much today as they are actually receiving.  (BTW, The average Social Security check as of September 2010 is $1072.20 per month, according to the Social Security Administration's figures.  The maximum for a retired individual is $2,346 per month.  Imagine if those figures were doubled.  Social Security would have been wiped out by now.  Williams says this is the real reason for changing the CPI calculations.)

Using the CPI to introduce a cost-of-living adjustment in government programs became law in 1972.  There have been minor adjustments throughout the years, but the substantial changes in methodology for calculating the CPI came in the early 1990s, long before TIPS were first sold in 1997.

I am not saying that TIPS are useless, or that they should be avoided for anyone's portfolio.  A bit of inflation protection in a bond simply adds diversity to the bond options out there.  It might be better than none at all. 

My point is that if we were to encounter any serious (double digit) future inflation, I would not be surprised if the methodology for calculating the CPI were to change again.  Not just to keep TIPS interest rates in check, but to keep all programs in check that have COLAs based on the CPI. 

If there were hyperinflation of 50%, I do not believe that the yields on outstanding TIPS would be allowed to ratchet high enough to protect a portfolio relying on them for inflation protection.  In that case, the Treasury Department might call all TIPS, pay off the principal and any accrued interest in nearly worthless dollars, and  cancel the product.  (But who really knows what Treasury would do?)

But if you had gold in your PP, you would not have to worry about this.  Its price in dollars is likely to skyrocket in that case, protect the entire PP from collapse, and save your assets. 

Sorry for the politics.  As someone else said, it's hard to explain concepts in the HB PP without an occasional resort to political economics.

[craigr]

In countries that experienced high inflation (Brazil, Argentina, etc.) it was very common for the govt. to understate inflation. You simply cannot rely on the people causing the inflation to report it correctly. Figgie International's Hyperinflation Survival Guide discusses these issues. This is an interesting book that used a team of economists to explore the effects of hyperinflation in Latin America and how companies dealt with the impacts.

[MediumTex]

If there were hyperinflation of 50%, I do not believe that the yields on outstanding TIPS would be allowed to ratchet high enough to protect a portfolio relying on them for inflation protection.  In that case, the Treasury Department might call all TIPS, pay off the principal and any accrued interest in nearly worthless dollars, and  cancel the product.  (But who really knows what Treasury would do?)

But if you had gold in your PP, you would not have to worry about this.   Its price in dollars is likely to skyrocket in that case, protect the entire PP from collapse, and save your assets. 

Sorry for the politics.  As someone else said, it's hard to explain concepts in the HB PP without an occasional resort to political economics.

Remember "Baghdad Bob" from the second Iraq war?

TIPS are sort of like the bond market equivalent of Baghdad Bob.

[Storm]

You all have some great points about why CPI doesn't reflect actual inflation.  Here's another one:  CPI intentionally excludes the 2 largest costs that most people have:  Housing and Energy.

If we had housing costs baked into the CPI we would be seeing huge amounts of deflation right now.  Likewise, on the inverse, we would have seen the real amount of inflation we had in the early 2000s when Greenspan started printing easy money for the MBS market.

[smurff]

Remember "Baghdad Bob" from the second Iraq war?

TIPS are sort of like the bond market equivalent of Baghdad Bob.

Good ol' Baghdad Bob.  The guy was official looking, gave official press conferences, had lots to say, and gave official answers to questions from journalists.  All, lies.  All while his country was being bombed to bits behind him.  He told so many lies that if it weren't a war, you'd have to laugh at him.  He even wore a beret!

[MediumTex]

Remember "Baghdad Bob" from the second Iraq war?

TIPS are sort of like the bond market equivalent of Baghdad Bob.

Good ol' Baghdad Bob.  The guy was official looking, gave official press conferences, had lots to say, and gave official answers to questions from journalists.  All, lies.  All while his country was being bombed to bits behind him.  He told so many lies that if it weren't a war, you'd have to laugh at him.  He even wore a beret!

Let's see if I can make a CPI MadLib:

Good ol' CPI.  The CPI was official looking, was released in official press conferences, had lots to say about price levels, and gave official answers to questions from journalists regarding inflation.  All, lies.  All while its country's currency value was being bombed to bits behind it.  It told so many lies that if it weren't for an international war on currency values, you'd have to laugh.  It even had the gall to exclude food and energy!

[Pkg Man]

You all have some great points about why CPI doesn't reflect actual inflation.  Here's another one:  CPI intentionally excludes the 2 largest costs that most people have:  Housing and Energy.

If we had housing costs baked into the CPI we would be seeing huge amounts of deflation right now.  Likewise, on the inverse, we would have seen the real amount of inflation we had in the early 2000s when Greenspan started printing easy money for the MBS market.

I'm not defending TIPS as an investment for the PP or otherwise, however, the CPI most certainly DOES include housing and energy costs.  There are various components of inflation that are measured and for certain uses some components are usually excluded.  But for purposes of TIPS and I-Bonds, the Treasury uses the full CPI-U.  The Fed generally uses the CPI ex food and energy since these components are quite volatile and they don't want to be making monetary policy based on changes that can easily switch back and forth over a short time.  This is the reason you often hear this number quoted in the press and may have assumed that certain items are excluded from each measure of inflation.

From the Treasury Direct Site:http://www.treasurydirect.gov/instit/st ... srlist.htm
"The index for measuring the inflation rate is the non-seasonally adjusted U.S. City Average All Items Consumer Price Index for All Urban Consumers (CPI-U), published monthly by the Bureau of Labor Statistics (BLS)."

Inflation rates can be found at the St Louis Fed FRED site:  http://research.stlouisfed.org/fred2/categories/9
The first two items listed are the full CPI for urban consumers and include everything, food, energy, housing, etc.  One is non seasonally adjusted and the other is seasonally adjusted.

[MediumTex]

PkgMan,

IIRC, doesn't the CPI use the concept of "owner's equivalent rent" to track housing costs rather than the price of housing itself?

Did this approach cause the housing bubble not to show up in the CPI on the way up and now might it be causing the CPI not to accurately reflect underlying deflationary forces?

[Storm]

You all have some great points about why CPI doesn't reflect actual inflation.  Here's another one:  CPI intentionally excludes the 2 largest costs that most people have:  Housing and Energy.

If we had housing costs baked into the CPI we would be seeing huge amounts of deflation right now.  Likewise, on the inverse, we would have seen the real amount of inflation we had in the early 2000s when Greenspan started printing easy money for the MBS market.

I'm not defending TIPS as an investment for the PP or otherwise, however, the CPI most certainly DOES include housing and energy costs.  There are various components of inflation that are measured and for certain uses some components are usually excluded.  But for purposes of TIPS and I-Bonds, the Treasury uses the full CPI-U.  The Fed generally uses the CPI ex food and energy since these components are quite volatile and they don't want to be making monetary policy based on changes that can easily switch back and forth over a short time.  This is the reason you often hear this number quoted in the press and may have assumed that certain items are excluded from each measure of inflation.

From the Treasury Direct Site:http://www.treasurydirect.gov/instit/st ... srlist.htm
"The index for measuring the inflation rate is the non-seasonally adjusted U.S. City Average All Items Consumer Price Index for All Urban Consumers (CPI-U), published monthly by the Bureau of Labor Statistics (BLS)."

Inflation rates can be found at the St Louis Fed FRED site:  http://research.stlouisfed.org/fred2/categories/9
The first two items listed are the full CPI for urban consumers and include everything, food, energy, housing, etc.  One is non seasonally adjusted and the other is seasonally adjusted.

Ok, riddle me this:  Take a look at this graph:  http://research.stlouisfed.org/fred2/se ... OSSL?cid=9

Then tell me how in the world they could be including house prices into their equation and have a steady rise all the way from 2005-2010?

Maybe they call housing "rent prices" or something silly.  But there is no way you can remove $trillions in (fake) equity from housing and not show massive deflation.

[Pkg Man]

Actually the CPI did not rise all the way to 2010, it began to decline in 2008, early into the recession.

You and MT are correct that the CPI uses "owner's equivalent rent" rather than the actual price of a home.  Fortunately, I do not make my living knowing the intricacies involved in the measurement of inflation, but what I do know does not make me think equivalent rent is a silly concept (if it is good enough for George Stigler, it is good enough for me).  This link will provide way more detail than I am able to http://www.bls.gov/opub/mlr/2008/08/art1full.pdf.  The owner's equivalent rent discussion begins on page 10.

Basically, owner's equivalent rent is used because the BLS treats housing as both an investment and a consumption item.  The consumption element of a home is shelter, and it is this component of housing that the BLS seeks to measure in the CPI.  To the extent that the rental value of my home has declined, it will (presumably--remember, this is all based on samples) be reflected in the CPI but the loss in the investment value of my home will not be.

Since the CPI can be sliced and diced into the various component parts, like food, energy, housing, clothing, etc, I don't think the way housing is measured in the CPI blinded the Fed in any way.  There were plenty of direct measures of home prices for the Fed to observe.  While during the housing boom it did reduce the CPI over what it would be if home prices were directly included in the index, and the opposite is now occurring, I don't see that as an issue based on what the CPI seeks to measure.  Home prices over-shot, and now they have corrected, but home prices do not always have a one-to-one relationship to the rental value of the property--hence the "bubble".  Many people were buying real estate solely as an investment (I came close) and this increased demand for the investment value of real estate drove up prices beyond what was reasonable given the rental values that could be obtained. 

Did home prices over-shoot based on Fed policy?  Probably, but changing the way the CPI is measured would not likely have changed the policy as it would not have provided them any information they did not already have.  Anytime the Fed funds rate is kept low for an extended period of time it has the potential to drive asset bubbles, most often in items that are not included in the CPI (stocks, bonds, commodities).  It just happened to be housing last time.

I am no expert on the CPI, but I think they have it right.

[smurff]

Let's see if I can make a CPI MadLib:

Good ol' CPI.  The CPI was official looking, was released in official press conferences, had lots to say about price levels, and gave official answers to questions from journalists regarding inflation.  All, lies.  All while its country's currency value was being bombed to bits behind it.  It told so many lies that if it weren't for an international war on currency values, you'd have to laugh.  It even had the gall to exclude food and energy!

Hilarious, MT!

[smurff]

Since the CPI can be sliced and diced into the various component parts, like food, energy, housing, clothing, etc, I don't think the way housing is measured in the CPI blinded the Fed in any way.   

TIPS are suitable for plenty of financial purposes, including being part of a variety of different portfolios, but not the Harry Browne Permanent Portfolio.  The Harry Browne Variable Portfolio, if that's what one wants, yes.

While the slicing and dicing, and the promulgation of so many versions of the CPI was probably not intended to enhance any kind of future mischief, it's easy to see how it could be used for that, if by no means than by confusion.  Just like stock in scores of individual companies like Enron, MCI-Worldcom, Pets.com, etc. were used for serious mischief in the late 1990s, and slicing and dicing (making "tranches") of mortgage notes in the 2000s has caused some serious, ongoing trouble in the current economy.

My point was that physical gold is physical gold.  Aside from the obvious, facile, and easily discovered  frauds--enclosing tungsten ingots/blanks with thick gold plating to make them look like gold bars/coins, shaving pieces from the edges of bars/coins, punching holes in the coins, diluting it to less than 99.X% purity, etc.--it can't be manipulated, massaged, redefined, etc.  by any known and usable technology in this galaxy into something that it is not.  I'm not referring to paper gold fraud or to gold market manipulation, which can be done (and has been done, according to GATA) over a short term.  I am referring to changing the essential characteristics of gold--that which makes it the element Au--itself.

But manipulations, massages, and redefinitions (along with other mischief) are possible with TIPS.  They might be done in such a way that when the true inflationary protection of gold in the portfolio is needed, TIPS are likely to fail at that because the statistical models the CPIs are based on are easy to fudge.  Discovery of any manipulation might even happen quickly, but the acceptance of the proof of such manipulation will be long after the fact as debates rage over what really happened.

We're still debating what price changes in rental vs. investor housing mean in the CPI in 2010--just as they were doing in the 1990s, the 1980s, and beyond.  But humans have agreed on what gold is--money--for thousands of years of human civilization.

[Storm]

Good points, smurff.  I think we can all agree that the CPI can be easily manipulated by humans, where gold cannot.