TIPS From Gold

"We are at a wonderful ball where the champagne sparkles in every glass and soft laughter falls upon the summer air.  We know, by the rules of experience, that at some moment the Four Horsemen of the Apocalypse will come shattering through the great terrace doors, wreaking vengeance and scattering the surviving guests.  Those who leave early are saved, but the ball is so splendid that no one wants to leave while there is still time.  But some pause and ask "What time is it?  What time is it?"  Alas, none of the clocks have hands." - Lucky Christov

Treasury Inflation Protected Securities (TIPS) are bonds issued by the US Treasury.  The idea behind TIPS is to protect you against inflation.  The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index.  When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater.   Interest is paid twice a year, at a fixed rate.  The rate is applied to the adjusted principal; so, like the principal, interest payments rise with inflation and fall with deflation.

Protection against inflation is also sought in the precious metal market with gold and silver.  Both of these but particularly gold rise when inflation expectations rise.  So in some respect TIPS and precious metals move in tandem to one another and in lock step with inflation expectations.  As I have recently mentioned gold and silver have taken an almighty pounding recently.  Along with this pounding, TIPS have seen their price fall precipitously, so both of these investments point toward deflation.  The question becomes what happens to stocks in a deflationary environment and is deflation even possible?

The first part to the question is relatively easy to answer as every time deflation enters the door, stock markets dive off a cliff.  Deflation is the worst possible environment for stocks for the simple reason that not only do asset prices fall during deflation but it is incredibly difficult to get an economy moving once you enter the deflationary spiral.  Consumers shut their wallets as prices will be cheaper tomorrow than they are today so large expenditures are shunned.  This feeds into company earnings which remain lackluster and with this outlook stocks plummet.  For a simple example look once again at Japan whose market index the Nikkei sits at 14,500 down from an all time high of just under 40,000 more than 20 years ago!

The second part to the question is very tough to answer as it all depends on what you use as your gauge of inflation.  As I mentioned a number of blogs ago, inflation should almost be measured by each individual as we all have different inputs and price drivers.  This measure however will never drive markets.  What drives them is general consensus and this consensus comes from evaluating the TIPS and gold markets for clues and with both of these markets in the doldrums inflation expectations are teetering at critical levels.

Fortunately since the Federal Reserve recanted their earlier statements of slowing down the level of asset purchases these two markets have made a recovery (as has the stock market which once again made new highs this week), but it is worth keeping a close eye on these two indicators as you cannot have a falling TIPS price and falling gold prices without a collapse in the stock market prices.