That Bob Brinker. While some people think the sun rises and sets with his financial advice, I have to take him with a grain of salt. But then I don't know anyone who has consistently been correct on market forecasting.
For example, Brinker completely missed the latest crash. However, his radio show on more than 400 stations is popular with millions who tune in regularly, and his newsletter is full of good advice. If you don't want to tune in, you can read an interpretation of the show by subscribing to the online newsletter by David Korn.
In the good advice department, Brinker has always made the point that a reasonably accurate predictor of inflation rates is the difference, or spread, between interest paid on 10-year bonds and the rate paid currently on Treasury inflation-protected bonds known as "TIPs." The latter are bonds with an interest rate that rises with the rate of inflation.
Last week, a milestone was reached as people actually paid money for the privilege of loaning money to the U.S. government. You read that right. Instead of making a loan and receiving interest payments in return, people made loans (bought TIPs) and paid for the privilege. If there's no additional inflation for the next 10 years, they will never see a dime of earnings.
Sorting it out
Why does the spread between the interest on TIPs and regular bonds amount to a harbinger of inflation? Because what people sacrifice today to assure themselves more income tomorrow is telling us what they expect the inflation rate to be. Confused?
Consider a $1,000, 10-year bond today that paid 2 percent per year. You would receive $20 per year and a total of $200 in interest over 10 years and then get your $1,000 back. The return is pitiful, I know, but that's beside the point. What happens if inflation spikes up in, say, five years and suddenly bond interest rates on brand new bonds are paying 8 percent. (Something similar happened in the fall of 1987.) Your old 2 percent bond, if you wanted to sell it right then, will have just dropped precipitously because it competes with new bonds that pay $80 a year in interest.
You're stuck taking the loss if you sell or hold your bond until it matures -- meaning you hold it for the remaining five years to get your full $1,000 back.
Today's 10-year TIPs pay zero interest. To understand how the spread between TIPs interest and the interest paid on regular bonds predicts inflation, we'll keep the illustration simple. Buyers of regular bonds today are reasonably certain that inflation will remain at just 2 percent for 10 years. That's why they're satisfied with a bond that pays 2 percent. At least they're treading water.
Let's say that inflation is 2 percent for the next five years, and then it leaps to 4 percent and stays there for the remaining five years of the 10-year bond. If we had bought the TIP that pays no interest today, we would get zero interest for the first five years and suddenly start receiving $40 per year for the second five years when inflation leapt up.
Doing the math
In both 10-year bonds, regular and the TIP, we are getting a total of $200 over 10 years. However, we accepted a bond that paid zero today, because we were reasonably convinced that inflation would jump to at least 4 percent (the break-even point) forcing the 10-year bond to pay $40 or more per year for the last five years -- the same $200 total as the regular bond.
If we go to the trouble to buy a bond that pays nothing today, we're expecting inflation to be even more than the 4 percent in the example. The 4 percent was just the break-even point at which our choice of the TIP stopped being a bad decision.
Inflation might turn out to be even more, but today's 2 percent spread between the zero-interest TIP and the regular bond paying 2 percent is the forward indicator of what bond buyers think inflation will be. In the interests of simplicity, this example ignores time value of money and compounding for those who were wondering.
If we agree with Bob Brinker and consider the spread to be a reasonable indicator of future inflation, is this "The Wisdom of Crowds" (good) or is it "The Behavior of Crowds (generally bad)?" TIP's haven't been around that long as a financial invention, so we don't really know whether this free market bond pricing reflects intelligent thinking or just a herding instinct like lemmings.
If this unanswered puzzle gives you a headache, the alternative is to invest in short-term bond funds whose interest will rise with inflation and still pay something today.