The spread between Treasury Inflation Protected Securities and non inflation protected securities is supposed to be equal to the market consensus for future inflation expectations, and is commonly cited as reasons not to fear inflation on the horizon- but this is very clearly a bullshit measurement for multiple reasons.
The TIPS spread massively understates the highest inflation rates. Say I figure that there is a 50% chance of a 100% inflation rate next year and a 50% chance of a 0% inflation rate next year- would I buy TIPS? If 0% rolls around I get no benefit from having TIPS (I would have been better off in regular T-Bills) – but what happens if prices double? If prices double then SS and Medicare/Medicaid payments are going to the moon as well- considering they comprised 43% of the federal budget in 2008 and ~9% of GDP a large jump (along with the massive dislocations coming from such a jump) would threaten Goverment solvency. My default risk goes up the value of my principle has been cut in half- and in general I didn’t do very well despite predicting a massive calamity. The value of the TIPS spread lies in the outcomes in which holding US dollars isn’t painful (or at least massively so). If I truly belived that inflation would run rampant any wise investor would look to other sources for protection- commodities, land etc- all do much better than payments in fiat currencies during high inflation times- unless those bets are tied to multipliers higher than inflation.
This leads me to the 2nd point- about CDSs. Many point to the Default spreads and say “this is the risk of the US government defaulting”- which is again bullshit. What would happen to the US dollar if the federal government defaulted on its debt? Remember the dollar is backed by the “full faith and credit of the US”- what happens to someones credit when they default? What happens to your faith in them? What is the value of getting paid in “full” in dollars if the dollar is worthless? If you were talking about- say Mexican government debt where the CDS was paid out in a fixed exchange rate for Dollars that might mean something- but when your payout’s value plummets when conditions occur that would allow you to collect the payout those rates start to mean nothing. To illustrate this Japan’s rates recently nearly doubled to 63 basis points. That’s 0.063% a year to insure against the default of a country that is approaching (quickly) a 200% debt to GDP ratio, has horrible demographics, just announced a $500 billion dollar bond auction and has had a garbage economy for 20 years. Their risk of default is 0.063% a year? Ha.
Of course you could argue- briefly- that one could price the payout in something else- like EUROs. Hypothetically- what happens to the value of the EURO, YEN, YUAN, DOLLAR, PESO etc should the US default on its obligations? They would go up relative to the dollar, but they would go down relative to just about every thing else. Better hedges exist and so the only people buying CDS swaps are those that are contractually or legally obligated to hedge their positions- hence the CDS swap market (for forgein debt) represents only a fraction of the real market.
