There are plenty of things available for people to worry about these days. I won’t even begin to list them out as they are too numerous to really mention. Interestingly though, one thing that I hear very few people being concerned about these days is inflation. Anyone who still bears the emotional scars of the high inflation of the late 70’s and early 80’s (“Hi, my name is Jay”) may be somewhat wary still. But for just about everyone else, inflation concerns are nowhere on the radar.
Now typically this is where the author pivots to the “Aha, you fools” argument and begins to list all of the reasons that inflation is “just around the corner” and all of the “inevitable” impending devastating effects. Alas, I don’t really have enough ammunition to make any kind of argument along those lines. At the moment inflation is pretty tame and my crystal ball that I would normally use to peer into the future broke a long time ago (unfortunately I continued to stare into the damn thing long before I realized it didn’t actually work, but I digress).
Still, it never hurts to “be prepared”. So here goes. “TIPS” stands for “Treasury Inflation Protected Securities” (some marketing guy or gal somewhere must have gotten a decent bonus for coming up with that one). If you want to know all about them I suggest Google. For our purposes just know that the interest rate paid on a TIPS bond can fluctuate higher if inflation rises – i.e., they offer some protection from higher interest rates that regular bonds do not. TIP is an ETF that tracks an index of TIPS securities.
Ticker TLT tracks the standard 20+ year treasury bond. This bond has the most direct exposure to interest rate, i.e., if long-term rates go down a lot these bonds can go up a lot in price and if long-term rate go up a lot these bonds can down a lot in price.
Figure 1 displays ticker TIP on the top and ticker TLT on the bottom. Note that sometimes they move together, sometimes they move apart and note also that TLT is almost always more volatile that ticker TIP.
Figure 1 – Ticker TIP divided by ticker TLT (daily, 12/5/2003-12/13/2017)
Figure 2 tracks the ratio of TIP divided by TLT from 12/5/2003 through 12/13/2017 along with the 2500-day exponential moving average.
Figure 2 – TIP/TLT Ratio with 2500-day exponential moving average (daily, 12/5/2003-12/13/2017)
The bottom line: If the ratio is trending lower and is below the 2500-day EMA then inflation fears are low and vice versa. As you can see the ratio and the trend line are generally trending lower. This suggests that perhaps people are right not to be too concerned about inflation at the moment.
A couple things to keep in mind:
*This by itself is not a “trading” indicator, only a “perspective” indicator. As long as the ratio is below the moving average there is probably not a big need to worry about “hedging your investments” against inflation.
*Once that changes though, the dangers of potential inflation should at least be considered.
As a Bond Market Indicator
As it turns out this indicator can be used to trade in the bond market – although the method is somewhat counter intuitive. Still, because I am only pointing out the possibilities and NOT recommending that you actually use it to trade bonds, here goes:
*Figure 3 displays the TIP/TLT ratio with 3 exponential moving averages (using daily data). They are the 10-day EMA, the 1200–day EMA and the 2500-day EMA (daily, 12/5/2003-12/13/2017).
Figure 3 – TIP/TLT Ratio with 10-day, 1200-day and 2500-day exponential moving averages (daily, 12/5/2003-12/13/2017)
Our Test Bond Model works like this:
*If the 10-day EMA is below the 1200-day EMA then we add +1 point
*If the 1200-day EMA is below the 2500-day EMA then we add +1 point
*So for any given day our Test Bond Model can read 0, +1 or +2.
Figure 4 displays the growth of $1,000 since 2003 generated by holding ticker TLT depending on whether our Test Bond Model reads +2 (blue line) OR less than +2 (red line). As you can see, the long-term bonds did pretty well when the Model was less than +2 and have been pretty choppy when the Model is at +2.
Figure 4 – Growth if $1,000 invested in ticker TLT when Test Bond Model < +2 (red line) versus growth of $1,000 invested in ticker TLT when Test Bond Model = +2 (daily, 12/5/2003-12/13/2017)
For the record:
*$1,000 invested in TLT ONLY when our Test Bond Model is less than +2 grew to $1,764, or a gain of +76%
*$1,000 invested in TLT ONLY when our Test Bond Model is equal to +2 declined to $841, or a loss of (-16%)
Despite these apparently useful results, no one should start trading long-term bonds using this simple method without doing so serious research on their own.
Summary
At the moment, scant fear of inflation seems reasonable based on the continued lower to sideways trend of the TIP/TLT ratio. Likewise, the Test Bond Model is firmly planted at +2 so no position in TLT would be held based on this experimental model.
Jay Kaeppel
Disclaimer: The data presented herein were obtained from various third-party sources. While I believe the data to be reliable, no representation is made as to, and no responsibility, warranty or liability is accepted for the accuracy or completeness of such information. The information, opinions and ideas expressed herein are for informational and educational purposes only and do not constitute and should not be construed as investment advice, an advertisement or offering of investment advisory services, or an offer to sell or a solicitation to buy any security.
