Treasury Inflation-Protected Securities

These are words that investors in Treasury securities don’t like to read:

Standard & Poor’s cut its ratings outlook on the U.S. to negative from stable while keeping its triple-A rating on the world’s largest economy. Relative to its AAA-rated peers, the U.S. has very large budget deficits and rising government indebtedness, and the path to addressing those issues is unclear, S&P analysts said.

Yes, the U.S. keeps its AAA rating, but the massively high deficits are worrying the world, even as the rest of the world is acting to slow down inflation by inching up interest rates. (U.S. fiscal policy has also been rewarding borrowing and risk, while slamming savers with near-zero interest rates.)

We believe there is a material risk that U.S. policymakers might not reach an agreement on how to address medium- and long-term budgetary challenges by 2013; if an agreement is not reached and meaningful implementation is not begun by then, this would in our view render the U.S. fiscal profile meaningfully weaker than that of peer ‘AAA’ sovereigns.

The stock market is not liking this — the Dow average is down nearly 2% this morning.

This needs to serve as a wake-up call to Washington.

The Treasury’s response

A senior Treasury department official – assistant secretary Mary Miller – had this response to the S&P action:  “We believe S&P’s negative outlook underestimates the ability of America’s leaders to come together to address the difficult fiscal challenges facing the nation.”

Another interesting video from FT.com on inflation:

George Goncalves, head of US interest rates strategy at Nomura Securities, tells the FT’s Michael Mackenzie that he does not expect to see substantial inflation in the near future. Mr Goncalves says higher commodity prices are a tax on society but not inflationary.

Watch the video

Point to ponder: If you agree with Goncalves that inflation is being overestimated, this week’s 5-year TIPS, which will probably go at a negative base interest rate, is pretty unattractive. It’s still a no-risk investment when held to maturity, but better opportunities might arise within a year.

From FT.com, a fairly optimistic viewpoint from Henry Kaufman.

Henry Kaufman, the legendary Wall Street economist known as “Dr Doom” for his pessimistic forecasts on inflation and interest rates in the 1970s and 1980s, says he does not like his nickname but understands that it reflects people’s unwillingness to hear a negative view or bad news. He says the US is not in the inflationary period of the 1970s.

Watch the video

Larry Swedroe of Wise Investing posted a good analysis today on CBSMoneyWatch.com, talking about the the risk/rewards of TIPS versus conventional Treasuries.

Read his post.

He makes the case that even though the base yield on the 5-year TIPS is low by historical standards, it still makes sense when measured against a traditional 5-year Treasury. He says:

“The current yield on the five-year nominal Treasury is about 2.2 percent. With the Philadelphia Fed’s five-year inflation forecast at 2.1 percent, the expected real return is 0.1, meaning it’s still about 0.3 percent higher than the comparable TIPS yield. Again, given the relatively small risk premium, TIPS are still the preferred choice.”

Of course, there is a lot of other ways to invest your money, outside of Treasuries. But if you are looking for safety without inflation risk, buying this upcoming 5-year TIPS and holding it to maturity looks like a solid – if very boring – investment.