Argentina has used inflation to shirk its debt without an official default. Investors should ask how calculations of the CPI might someday be used to devalue TIPS.
On February 25, The Economist delisted the official inflation statistics from Argentina, because the government has "published inflation figures that almost nobody believes." Don't Lie to Me, Argentina describes how President Christina Fernández de Kirchner forcibly installed party loyalists at INDEC, which publishes the inflation statistics. From 2007 onward it has been all downhill, and unofficial estimates of inflation in Argentina are now about 25%, vs. the official figure of just 10%.
Could It Happen Here?
Although I don't believe that the U.S. will actually default on its TIPS obligations, it made me think "What is default?" This actors in the Greek bond drama dance around the meaning of the word, lest a "collective action clause" trigger a legal default that would force payments on credit default swaps (CDS). Last week Felix Salmon described how a Greek bond swap would kill the sovereign CDS market. Regardless of whether it's CDS or Argentine bonds, confidence lost in legal maneuvers is not easily regained in financial markets.
Back to TIPS, which certainly aren't cheap these days. The CFA Institute recently dedicated a cover story discussing the potential overvaluation of TIPS after a decade of strong returns (login required). Many investors own TIPS through TIP, the $22 billion fund from Barclays with the long-winded name: The iShares Barclays Inflation Protected Securities Bond Fund (TIP). TIP has a negative real yield these days of 0.63%, so I guess that these securities were bought at a premium, and must generate returns from future adjustments to inflation. (That's the best I can make of it, anyway.) What future inflation rate does TIP assume? Well, since the 10-year bond is now yielding 1.99%, Bloomberg estimates that TIP now discounts a 10-year break-even inflation rate of 2.3%.
Inflation of 2.3% over the next 10 years - is this realistic?
The Bureau of Labor Statistics calculates headline CPI, the measure used to adjust the principal value of inflation-protected bonds included in TIP. Headline CPI, or CPI-U, was 3.2% last year, and the annualized rate reported in January 2012 was 2.9%. These are close to the long-term trend, though the record going back to 1913 shows that CPI jumps all over the place.
The methodology at the BLS has come under attack so often for so long, they actually published a kind of "myth-busters" article back in 2008. But without getting into a tedious discussion of owners' equivalent rent and hedonic adjustments, let's just agree that the CPI has a lot of assumptions in it. These assumptions could be right, and they could be wrong, but they are only that - assumptions. And assumptions are subject to political pressure.
If the U.S. gets in a deep enough hole because of its $15.5 trillion in debt, I think there will be a lot of pressure on the folks at the BLS. Perhaps it won't result in a wholesale purging of economists as Argentina did with INDEC; perhaps it will be more subtle. Changing the assumptions to the CPI could save a lot of money for the U.S. government (not just TIPS, but social security and other payments). The key for sovereign debt markets, is that a change in CPI assumptions does not count as a default. With billions of dollars at stake, I can easily envision a future administration tempted to imitate Christina Fernandez.
QE + ZIRP = Bond Bubble
I do not believe the bottom will drop out any time soon, and I am long TIP for client accounts. But devaluation of TIP through political machination of the CPI is on my mind, especially as the bond bubble continues to inflate. I like the way Andy Laperierre of ISI Group put it when he published an op-ed piece in Monday's Wall Street Journal:
During the past three years, the Federal Reserve has tripled the size of its balance sheet-in effect printing $2 trillion-something it had never done in its nearly 100-year history. The Fed has lowered short-term interest rates to zero and signaled that it will keep them at that level for years.
Laperierre closed with this warning, which is something that should be on the mind of every holder of U.S. bonds, including TIP:
During the bubble, Fed officials argued they couldn't spot bubbles in advance, but that an aggressive monetary policy response could limit the downside impact if a bubble were to burst. As it turns out, the dislocation from the housing bust and the financial crisis have been far more costly than almost anyone imagined. Shouldn't that cause policy makers inside and outside of the Fed to ask hard questions as it pursues its unprecedented campaign of quantitative easing and zero rates?
Disclosure: I am long TIP.
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