By Brett Arends
The initial version of this article contained a paragraph that was incorrectly phrased, making a claim opposite of the one the author intended. This has been corrected
Do you want to take a bet?
Inflation is running at 8% or higher, depending on how you count it (and who’s counting). The Federal Reserve is clearly panicking. And the markets are clearly panicking too.
So at this point, Uncle Sam would like to offer you a bet.
How would you like to wager your hard-earned retirement savings that inflation is going to collapse in very short order, and collapse so far, so fast that over the next five years the average will be less than 2.4%?
Read: Market Snapshot
Oh, and to make the bet even more interesting, here are some additional terms: If you win the bet, and average inflation comes in below 2.4% between now and 2027, you will make a very small profit—but if you lose the bet you could lose, and lose big.
How does that sound?
If this sounds completely nuts to you, you are not alone. It sounds pretty nutty to me too. But here’s the sting in the tail: You may already be making this bet, without even knowing it. Actually, the more cautious and risk-averse you are, the likelier you are to be taking this bet.
I am talking about investments in U.S. Treasury bonds.
With inflation nudging toward double digits, 5 year Treasury bonds /zigman2/quotes/210598277/delayed XX:FVX +2.66% are paying 4% interest and 10 year Treasurys /zigman2/quotes/210598274/delayed XX:TNX +2.44% 3.7%. The longest-dated bond, the 30 year, is paying 3.6% interest.
These may or may not prove to be successful bets, depending on what happens next with inflation and the economy. Everything that needs to be said about predictions was made by Casey Stengel: “ Never make predictions, especially about the future .”
But in this particular instance we have an extraordinary puzzle: While regular Treasury bonds offer the interest rates just mentioned, a parallel set of Treasury bonds offer another set of interest rates with locked in guarantees against persistent inflation. And the prices look…well, weird.
So-called TIPS bonds, which stand for Treasury inflation-protected securities /zigman2/quotes/200600110/composite TIP -0.03% , are a niche product issued by the U.S. Treasury that come with the same guarantee against default as regular U.S. Treasury bonds, but with prices and interest payments that adjust automatically to account for inflation. (The mechanism is so mind-bogglingly complicated that any attempt to describe the inner workings would confuse more than illuminate. Suffice it to say that if you buy a TIPS bond and hold it to maturity, you’ll get the inflation rate every year plus or minus a determined “real yield,” depending on the price you pay when you buy it).
Right now if you buy 5 year TIPS bonds you can lock in an interest rate of about 1.6% per year plus inflation. If inflation averages 0% over the next 5 years, you’ll earn 1.6% a year. If inflation averages 10%, you’ll earn about 11.6%. And so on. You get the picture.