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Conclusion: Treasury Inflation Protection looks overvalued here, especially given the asymmetry associated with the long side of the USD. In fact, TIPS appear to have asymmetric downside risk, absent further monetary easing out of the Federal Reserve.

Position: Short the iShares Barclays TIPS Bond Fund (TIP).

This morning, Keith shorted the iShares Barclays TIPS Bond Fund in our Virtual Portfolio on the expectation that the demand for Treasury Inflation Protected Securities will wane in the coming months as the leading indicators for the slope of inflation (input costs in the form of energy, food, and raw materials prices) continue to make lower highs, consistent with our 1Q12 theme of Deflating the Inflation II.

As you recall, we took a brief respite from that theme immediately following Bernanke’s JAN 25thpledge to extend ZIRP to 2014, which we viewed as a headwind to our bullish view on King Dollar – the most notable of many factors driving commodity prices, in our opinion. Following a few weeks of taking the Fed’s queue and being bullish on assets correlated to inflation, we are now view the topping process in the Inflation Trade as a leading indicator for disinflation and, thus, are inclined to short TIPS.

Already broken from a TRADE-duration perspective, the TIP etf is flirting with a TREND-duration breakdown per our quantitative risk management model:

Asymmetric Downside?: TIP Trade Update - 1

We’ve made this point in previous notes, but absent a commensurate pickup in employment growth and wage inflation, accelerating input costs do little more than slow growth on a lag. While it can be nice to watch “risky assets” (equities, commodities, HY credit) all trade higher in unison and tell stories about accelerating demand/economic growth,  the reality of the situation remains is that we have a central bank that remains committed to perpetuating inflation due to a classical economic theory that views that as a prerequisite for employment growth.

Looking forward, however, the chart of the U.S. Dollar Index is telling us that from an intermediate-term TREND (bullish) and long-term TAIL (bullish) perspective, the current state of monetary policy backing the U.S.’s currency will come under increasing scrutiny and relegate Bernanke and Co. into an increasingly smaller box or, potentially, out of their roles altogether. Either way, further USD strength will have a negative effect on global commodity prices and assets that are highly correlated with inflation. The CRB Index (a basket of 19 commodities including crude oil) is breaking down and its quantitative setup inversely mirrors that of the DXY’s:

Asymmetric Downside?: TIP Trade Update - 2

 

Asymmetric Downside?: TIP Trade Update - 3

All told, Treasury Inflation Protection looks overvalued here, especially given the asymmetry associated with the long side of the USD. In fact, TIPS appear to have asymmetric downside risk, absent further monetary easing out of the Federal Reserve – which, in our view, poses a dramatic risk to U.S. growth, given that we’re already in the midst of an oil price shock!

Darius Dale

Senior Analyst