As Faith in the Almighty Dollar Erodes, There's Hope in TIPS

Inflation-indexed bonds are good for retirement plans as well as the U.S. dollar.
by | September 17, 2009
 

In case you haven't noticed, the U.S. dollar is slowly losing its dynastic role as the world's reserve currency. Foreign central banks and sovereign wealth funds are beginning to put new money into "Special Drawing Rights" of the International Monetary Fund, which contain a basket of currencies. Brazil, India, China and Russia recently stated a preference for an alternative to dollar reserves. That bodes ill for U.S. inflation in the future.

The Chinese in particular are playing from a position of strength versus the U.S. position of weakness. Their massive trade surpluses give them huge reserves, which they are investing for the long term in natural resource producers (copper, iron, coal) as well as U.S. Treasury bonds. They naturally fear a secular decline in the U.S. dollar, which would cheapen their investments.

U.S. pension fund trustees and retirement investors should take notice. What's bad for the Chinese would also be bad for you. A weaker dollar will eventually bring U.S. inflation, which is the bane of retirement investors. Pension funds and 457 accounts cannot keep up with inflation, especially with their bond portfolios. The 1970s proved that inflation is also the enemy of the U.S. stock market as companies must replace physical plant and equipment with higher-priced capital stock -- while competing with higher bond yields in the financial markets.

Treasury Secretary Timothy Geithner has a potential weapon at his disposal that deserves more consideration than it's been given lately: He can increase the issuance of Treasury Inflation-Protected Securities (TIPS) to give investors better protection against inflation while bolstering the dollar. Treasury has already announced that it will sell more TIPS to the Chinese and other foreign purchases. Now it needs to make this a general debt management policy.

Here's why: Governments that sell fixed-rate bonds perversely benefit from inflation because they can repay their debts with a depreciated currency. So inflation is good for spendthrift governments -- until the economy collapses as a result. This forces investors to seek higher interest rates to compensate for inflation risk and the central bank (here, our Federal Reserve) to raise interest rates at the risk of killing the economy. By issuing Treasury bonds with an inflation kicker, those risks are then borne by the U.S. government and not retirees and pension funds. Moreover, the foreign investors will regain confidence that their investments will retain their value and thus be less prone to demand a new reserve currency.

If the U.S. Treasury sells perhaps 33 to 50 percent of its longer-term debt (maturities of seven to 30 years) in the form of TIPS instead of fixed-coupon bonds, several benefits will inure:

o Investors can hedge against inflation risk. Pension funds and retiree medical trust funds would find these natural investments. They can accept lower rates on their bond investments if they know inflation is offset.

o Private corporations could issue their own inflation-adjusted securities with even higher yields, using TIPS as hedges through swap agreements. Companies with inflation-sensitive products ranging from corn to copper to health care could reduce their borrowing costs because they are naturally hedged. Pension funds would find such bonds even more attractive.

o Future politicians will be better disciplined to control inflation, because their budgets (not today's) pay the price for a jump in the inflation rate. This is the monetary equivalent of Ronald Reagan's tax strategy: "Take the revenues away and they can't spend it." In the fiscal world, inflation-based interest payments would force the Congress to find long-term solutions to the debt and entitlement mess. Loose-money politicians would have to eat their own cooking.

o The Federal Reserve would no longer be the only inflation-fighter in Washington. That should help keep interest rates lower, which reduces the risk of a 1981-style double-dip recession.

TIPS alone will not solve America's structural deficits, chronic trade deficits and the growing mountain of retiree entitlements. I don't know if we can retain our status as the world's reserve currency beyond the next decade as the global economy morphs into a brave new world. But TIPS are one counter-measure that our Treasury Secretary can deploy immediately without a vote of Congress--once the debt ceiling is raised. Public and pension officials should support this strategy.

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