Citizen Economists » TIPS

Please Steal From Us – A Lesson From TIPS

Trace Mayer — Fri, 13 Mar 2009 13:30:31 +0000

WHAT ARE TIPS

While perusing the internet scrounging for investment vehicles I stumbled across an article suggesting Treasury Inflation Protected Securities (TIPS). With TIPS the government agrees to borrow FRN$’s at a specified interest rate. The creditor receives interest payments based upon the invested principal. Also, the government promises to adjust the principal periodically throughout the year to reflect the loss of purchasing power resulting from inflation during the period.

On its face, this appears like a safe and secure investment. The creditor receives modest interest income by lending capital to the government and are compensated for it and therefore do not bear the downside risk of devaluation through inflation. Surely many retirees must feel warm and fuzzy with this instrument that performs like a stock that pays both a cash and stock dividend. As the instruments are guaranteed by the venerable United States government surely any investment advisor could recommend TIPS to anyone.

SNEAKY TRICKY GOVERNMENT

A deeper review reveals a dirty little government trick. But first a question. Assume 0% interest. If you invest $100,000 in TIPS for a year and the government declares the inflation rate to be 3% and after a year you redeem at $103,000; did you make an economic profit? Did you have a gain on your investment? Technically the government’s own decree is that you have not had economic profit. The TIPS principal is in the exact same economic position as a year earlier.

This is fine until you file your tax return and the government attributes to you $3,000 of taxable income. The less astute may not bat an eye as the government is simply doing what it does best, taxing you. The government concedes no economic profit because of inflation but still assesses a taxable gain.

If you assume a 25% tax rate, that would mean the government has managed to rob almost 1% of your purchasing power in just 1 year. Yet, no one complains because the amount of FRN$’s increased overall. Over 15 years the loss of purchasing power would be a slightly over 10% by investing in the very instrument the government asserts is designed to protect you.

NOT LIMITED TO TIPS

This scenario plays out in hundreds of examples where there is a taxable gain but an economic loss or loss of purchasing power. Real estate, stocks, bonds and commodities are all affected by inflation and investors get taxed through inflation without representation or due process of law. Have a 3% gain on real estate? Pay tax and end up behind. An 8% return on a stock portfolio? Well, 3% was courtesy of the government and now “the people” have the audacity to force you to give a share back.

Many assert that inflation is a tax. I partially agree. Theoretically in a predictable inflationary environment all assets rise together. Real estate, stocks, bonds and commodities all rise as the illusory currency evaporates. I am unaware of any government that permits concessions for currency debasement when taxing businesses and citizens.

This reveals the perniciousness of the inflation tax which results when there is either no economic gain or an economic loss yet taxation still results, it is unavoidable and pervasive. Even worse, the poor are most affected as they have no assets to rise with the illusory tide.

A gold ounce is an excellent example. In 2001 a gold ounce is purchased for $275. In 2008 the gold is traded for either $975 FRN$s or the equivalent amount of goods or services. The gain would be $700 even though the useless gold ounce did not change, grow or become scarcer in the world. Now the government demands a $200 share. Why?!?

Well, the government assert there is a gain and they want their cut whether they deserve it or not and are willing to use force to get it. Gold is especially painful because of the automatically higher tax rate which is instituted to make it less competitive as a currency in ordinary daily transactions. This is an splendid reason to support sound money legislation like the Indiana Honest Money Act.

CONCLUSION

I am not among the gold bugs that assert gold is a perfect inflation indicator because I find that with the random volatility, or lack thereof in the 90’s, gold is too volatile in the short run. Nevertheless, in the long run gold has been a great indicator of a competing currency’s value and is signaling that almost all are eroding fast. Even worse; all the governments are taxing businesses and citizens the entire way down during the great credit contraction.

This is a wonderful example of why businesses and individuals play tax games to reduce their exposure. But they are not the only ones. Who decrees the inflation rate used in the TIPS calculation? Yep, that same government that promised to adjust the TIPS so the investor would remain whole … before the taxes of course. There is surely no conflict of interest and people like John Williams of ShadowStats must be loony to assert that the inflation rate is understated. For these reasons TIPS are almost always an invitation, not that they care to ask, from the government to steal from holders of capital.

Falling Markets, Consider TIPS

Moyo Mamora — Wed, 25 Feb 2009 10:00:58 +0000

So far the hopes of a rebound in the economy appear slim in 2009. The markets have steadily traded downwards since the beginning of the year, wiping out all the gains that were seen last month of 2008. The question on everyone’s mind is where does the value exist currently? With deflation being the new buzz word thrown around, and the government seeking to “combat inflation at all cost”, by spending multiple billions of dollars that have been created from thin air, buying treasuries now doesn’t seem reasonable. Current yields for US treasuries are not particularly exciting/attractive, we have 3 month Treasuries sitting at a yield of 0.13%, 5 Year Treasury yield at 1.48%, one has to lock up funds for a 30 year period to get an interest rate close to 3%.

Many investors and fund managers have justified their loans to the US government at 0% by stating that it’s much safer to have your money whole at the end of three months, as opposed to investing in an extremely volatile market or in a bank that may collapse anytime soon. News from RBS and Bank of America have not provided any warm fuzzy feeling in the market, and may have exacerbated the fear of the market dipping below it’s November lows, so very few dollars are flowing back into the stock market currently because of the perceived increased volatility.

(click to enlarge chart)

With that being said, it’s worth taking a look at intermediate and long-term Treasury Inflation Protected Securities, or TIPS. Taking a look at the chart of the 10 Year Treasury constant bond vs. the 10 Year Treasury Inflation adjusted bond, we see the market is technically pricing in deflation as the major concern, hence the near 0% rates being seen. This in itself is misleading, technically from the chart inflation is a concern, but fundamentally billions of dollars that were initially parked in stocks and money market accounts in the face of this economic crisis have been moving into US Treasuries as a safe haven. With the economic bailout looking more like a 2 or 3 Trillion dollar job, long term inflation is a certainty.

Based on the chart above, the market is projecting approximately 0% cumulative inflation over the next 10 years, but the Fed projects that we’ll see a negative number for inflation, or rather deflation, and they have employed a few mechanisms to fight this by setting the target Fed Funds rate to 0.25%, bailout monies, and absorbing bad debt from the balance sheet of financial companies, all of which will be monetized (by increasing reserves).

The graph below from the St. Louis Fed shows the progress being made in increasing reserves.

The Austrian school and the Keynes school both have varying perspectives on how to deal with the current economic situation. From a Keynesian view, and this is where the current Fed stands, printing money (or stimulating a moderate monetary inflation, which symbolizes economic growth) is the right way to handle the current economic situation.

The question then becomes how much money is too much money? Since economics is not an exact science, and many times various policies put in place to stabilize the economy usually have a delay before results are seen. More than likely, the government will continue to print more money until economic data begins to show a rebound in the economy, at this point the Fed would have injected enough money in the system to stabilize the economy, or more than is necessary to provide stability in the system, the result of which is inflation, the latter is often the case.

With this in mind, a safe haven investment will be an investment in TIPS, the value may not be seen in the short term, but inevitably as time goes, the effects of inflation will be seen and the value in TIPS will have added premium.

Learn more about TIPS and buying here at Treasury Direct.