Despite a rally over the last ten days following the shocking announcement that the Federal Reserve will spend $300 billion dollars to support Treasury debt, TIPS or Treasury Inflation Protected Securities continue to offer great value.

Though consumer prices might indeed turn negative in 2009 as the credit system continues to struggle, the longer term implications of money-supply expansion bode poorly for paper currencies and inflation expectations. This scenario makes TIPS a smart long-term speculation following a secular peak last July as inflation hit a nadir for the cycle.



For example, let’s assume a $1,000 TIPS was purchased with a 3% coupon and that during the first year inflation rose 10%. In this case, which I believe will occur over the next five years, the face value of the TIPS would be adjusted higher by 10% or to $1,100. Nominal or regular Treasury bonds don’t provide that protection.

The Fed, as part of its bold initiative to keep interest rates down to support mortgage lending has also announced it will start buying TIPS this week.

Ten-year break-even rates or the difference between TIPS’ yields and nominal Treasury bond yields sits at just 1.38%. This implies the market believes U.S. inflation over the next decade will average 1.38% per annum – unlikely in the wake of an avalanche of printing in Washington and other global financial centers. The Fed’s balance sheet, barely $800 billion dollars 12 months ago, now sits north of $3.6 trillion dollars as it grows desperate to swap almost worthless or illiquid assets for Treasury securities in order to get banks lending again.

In short, the Fed is out of control, introducing all sorts of financial gimmickry, including extending its arm beyond traditional financial borders to breathe life into the system. Thus far, there’s been very few takers with most credit spreads remaining historically elevated.

The United States and other economies to a lesser extent have chartered a course to monster-sized deficits in order to save the crippled financial system. Bank balance sheet risk is increasingly being transferred from financial institutions to government coffers where it’s likely to rot from poor liquidity and a severe bear market in mortgage-backed securities and other securities tied to incomprehensible synthetic derivative contracts. Treasury’s latest PPIP, or Public-Private Investment Program, will certainly help to boost liquidity in the mortgage-backed securities market if hedge funds and other risk taking institutions believe these securities will eventually appreciate.

With the exception of short-term government bonds, investors should avoid this asset class because a “bubble” of historical proportions is clearly in the making. The only government paper worth owning is TIPS where investors get the annual inflation rate in addition to the underlying coupon. That’s not the case with nominal bonds, which offer zero inflation protection.