Trading Tip: Ditch TIPS

This post first appeared on Minyanville.

Given the opportunity to bet on inflation 12 months ago, most investors would have fired up the Delorean without so much as a second thought.

Treasury Inflation Protected Securities, or TIPS, are designed to keep pace with inflation as measured by the Consumer Price Index, or CPI. The $500 billion market had once been considered a safe place to sock away funds as a hedge against higher prices. Amidst a barrage of screaming headlines about record oil and food prices, it may therefore seem strange that money managers are advising clients to bail on TIPS.

Bloomberg reports that Morgan Stanley (MS) and FTN Financial, a division of First Tennessee Bank, are suggesting clients move money invested in TIPS to securities that offer a better hedge against higher prices. Investors should bet on derivatives whose value is based on inflation expectations, rather than on the government’s shoddy data. They contend the methodology used to calculate the CPI doesn’t accurately reflect the true rate of inflation.

To Minyanville readers, this shouldn’t come as much of a surprise; Professors Mauldin and Depew have discussed the shortcomings of the CPI at length.

A primary criticism of the CPI is that it doesn’t properly account for fluctuations in food and energy prices. Historically, fuel and food have been more volatile than other consumer goods, so the Bureau of Labor Statistics (BLS) -- the government body tasked with tabulating the CPI each month -- strips out those costs to arrive at its “core” or headline CPI number.

The BLS also juggles the basket of goods used to calculate the CPI, which many contend allows it to distort the inflation rate. By swapping out expensive goods for cheap ones, it’s pretty easy to keep the most widely watched measure of inflation low - even while prices are obviously soaring.

A second factor that’s led investment advisers to steer clients away from TIPS is a divergence between the inflation expected by consumers and that reported by the government. Consumer sentiment readings indicate fear of higher prices, while traders betting on TIPS expect inflation to moderate over the next few years.

Some say this is just another sign of traders’ lack of faith in government data. Others, however, argue that inflationary pressures are actually decreasing as the credit crunch forces firms like Citibank (C), Merrill Lynch (MER) and General Motors (GM) to de-leverage.

Traders may be getting ahead of the curve: The debate highlights the importance of inflation expectations and their impact on consumer behavior.

If a rational consumer believes gas will be more expensive tomorrow than it is today, he'll make sure to swing by the Exxon-Mobil (XOM) station on his way home from work. If his view is the same tomorrow, he should fill up again - since prices will just be higher the following day.

This type of behavior leads to unnaturally high demand, as consumers shift purchases forward, pressuring supply. Increased demand coupled with dwindling supply means higher prices, which fuel more inflation expectations, pushing prices up even further.

Wash, rinse, repeat.

At some point, however, consumers are forced to give up; they simply run out of money.

The best cure for high prices may be high prices. As shoppers trade down, cut back and stash away their pennies for that inevitable rainy day, demand will diminish - and consumers will have no choice but to figure out how to get by on less.