While the market panics about deflation, Eric Fry says forward-looking investors can profit by swimming against the tide. The Inflation-protected Treasury bond ETF (NYSE:TIP) has never been cheaper, meaning a great chance for gains as the government’s mega bailouts feed through to higher prices.

But Eric says TIPs buyers must be cautious: a prolonged spell of deflation would be devastating to both prices and yields.

More from The Rude Awakening:

Everyone knows that a deflationary deep-freeze is paralyzing the global economy. Everyone also knows, therefore, that inflation is as good as dead. The sellers of stocks know it; the buyers of long-dated Treasury bonds know it; and the sellers of TIPs (Treasury Inflation-Protected bonds) know it better than anybody. When so many financial market participants are certain about anything, a forward-looking investor might want to challenge the thesis…and try to make a few bucks in the process.

The nearby chart shows quite clearly that prices of long-dated Treasury bonds (as represented by the iShares 20+ Treasury Bond ETF – NYSE:TLT) have been soaring, whiles the prices of TIPs (as represented by the iShares Treasury Inflation Protected ETF – NYSE:TIP) have been falling. Most long-dated TIPs have tumbled 15% in less than two months. Evidently, investors want nothing to do with inflation protection, but will stampede to obtain DE-flation protection.

But is deflation such an utter certainty that investors should be scooping up 10-year Treasury bonds that yield a near-record-low 3.11%?  To rephrase the question, is inflation such impossibility that investors should be unloading 10-year TIPs (Treasury Inflation Protected) that currently yield 2.40%, but could produce a vastly greater return if inflation heats up?

We ask these questions, not because we believe a deflationary episode is unlikely, but rather, because we do not believe that an inflationary episode is impossible. Investors in long-dated Treasury securities seem to have convinced themselves that inflation has been “deep-sixed,” not just for the next two or three years, but for the next 10 to 20 years as well.

The cost of taking the other side of that trade has never been cheaper. But TIP-buyers beware!…The other side of the trade is not without risks. A potent deflationary trend would depress the value of TIPs, both in absolute terms and relative to conventional Treasuries.  In such a circumstance, TIP prices could fall… a lot.  At maturity, of course, the TIP-buyer would receive at least “par” for his bonds.  But no investor wants to wait a decade or more to see the return of his capital.

[To better appreciate the virtues and vices of a TIP of security, consider the following brief primer: http://www.treasurydirect.gov/indiv/products/prod_tips_glance.htm]

As noted above, the conventional 10-year Treasury bond yields 3.11%, which is 71 basis points more than the 10-year TIP yield of 2.40%. The TIP-buyer accepts yield penalties like these in exchange for the comfort of inflation protection.

But comparing current yields is only one small part of the calculus that leads an investor to either buy or shun a TIP.  The most important aspect of the comparative analysis is the “implied breakeven inflation rate.”  In other words, what would the average inflation rate need to be during the life of a given TIP to make it a better buy than a conventional Treasury of the identical maturity?

During the last decade, the implied breakeven inflation rate for a 10-year TIP has fluctuated around 2% – meaning, if the inflation rate averaged less than 2% during the life of the TIP, a conventional 10-year Treasury bond would have been a better buy.  On the other hand, if the inflation rate averaged more than 2% during the life of the TIP, the TIP would have been the better buy.

Lately, a very strange thing has happened in the TIP market: breakeven inflation rates have collapsed to all-time lows. The 10-year TIP, for example, is pricing in a razor-thin inflation rate of just 0.3% per year during the next 10 years.  I.e, if the inflation rate averages more than 0.3% per year during the next 10 years, the buyer of a 10-year TIP at today’s prices would be better off than the buyer of a conventional 10-year Treasury bond.  The inverse would also be true.

Let the reader decide, therefore, whether the average U.S. inflation rate will exceed 0.3% per year during the next decade. But before deciding, let the reader also do enough homework about the quirky world of TIP securities to avoid making unintended errors.  One of the easiest – and costliest – errors a TIP-buyer could make would be to underestimate the capital-destroying potential of a severe deflation.  If the Consumer Price Index were to decline sharply for a sustained period of time, the price of a long-dated TIP would also decline sharply.  Furthermore, the current yield provided by the TIP would decline at the same time – a deflationary double-whammy.

Thus, the TIP buyer’s world is very simple: inflation = good; deflation = bad. But therein lies the appeal of these unique securities as well.  Inflation is rarely a good thing for the value of a financial asset, but it is a good thing for a TIP.

When the central banks of the world flood the global monetary system with titanic quantities of credit and currency, an inflationary uptick does not usually trail far behind.  And when the US Federal Reserve pours so many trillions of dollars into the US financial system that an $800 billion bailout seems like nothing at all, an inflationary uptick becomes increasingly likely.

TIPs are risky, but inflation is devastating.

Source: Beat the Rush; Sell Treasury Bonds Now