“Inflation” is an interesting, yet confusing topic. We interpret inflation to mean inflation of the money supply; ie. the rate at which a currency is being debased. However, “inflation” in finance pop culture has come to mean “price-inflation”, a slightly different concept. While “inflation” continues to grow the monetary base slowly and predictably, its evil twin, “price-inflation”, is the dominant factor for investors in the short run. Let’s shed some light on ways to measure price-inflation that make some sense.
Luckily, the US Treasury issues both fixed income treasury bonds (TLT etf) and price-inflation linked bonds called Treasury Inflation Protected Securities (TIP etf). TIPS are price-inflation sensitive bonds that adjust upwards in periods of price inflation, whereas normal fixed income bonds suffer in periods of inflation because the fixed size coupons a bond holder receives buy less goods or services.
The following chart is a ratio chart comparing the performance of TIPS in terms of long term Treasury Bonds: TIP/TLT. Additionally, the green line shows the amount of treasuries on the balance sheet of the Federal Reserve, with the purpose of illustrating the three QE programs and their impact on price inflation. On the hard right edge of this chart you can see that TIPS implied price inflation is as depressed as it was at the height of the 2008 financial crisis!
Next up is TIP/LQD, with the TED spread overlayed in green. The TED spread is a somewhat outdated measure of stress in the banking system. Consider this quote from wikipedia: “The TED spread is an indicator of perceived credit risk in the general economy, since T-bills are considered risk-free while LIBOR reflects the credit risk of lending to commercial banks.” These days the federal reserve has eliminated most of the inter-bank lending risk in the form of interest on excess reserves (IOER) replacing T-bills, and as expected, the investment grade corporate bond market (LQD) reflects it, as TIP/LQD hits new lows.
We would suggest that these two charts taken together imply that there is currently extreme price deflation, yet no financial stress in the banking system. This makes sense when you take into account what 0.25% interest on excess reserves (IOER) means for the big banking institutions. We will cover more on the important topic of IOER in the future.