By now we all know that the Federal Reserve’s suggestion of “tapering” its massive bond-buying program, aka quantitative easing (QE), has caused the return of volatility in both the equity and bond markets. Since Fed Chairman Ben Bernanke implanted the tapering bomb into the market‘s cortex on May 22, the markets have gyrated wildly, not just here at home, but also in Japan and emerging markets around the world. #-ad_banner-#

The hint that QE could soon be DOA also has caused a massive decline in one market segment that’s thought of largely as a slow, safe asset. That market segment is Treasury Inflation-Protected Securities, or TIPS.

TIPS are basically just government bonds with a built in mechanism that allows them to rise along with the most widely followed inflation metric, the Consumer Price Index (CPI). Unfortunately for TIPS owners, the threat of QE tapering and tame CPI numbers have combined to cause a race for the exits.

In fact, over the past eight weeks, the value of the iShares Barclays TIPS Bond Fund (NYSE: TIP) has plunged nearly 7%. The implosion in the sector has essentially erased about 18 months’ worth of gains, and TIP now trades at levels it hasn’t seen since October 2011.

The chart here of TIP shows the plunge in the sector since May, a rapid decline that easily took out both the 50-day and 200-day moving averages on the way down to those multi-year lows. The price action tells us that the market doesn’t think there’s inflation, and that even if the Fed begins tapering, and even if interest rates continue to rise, there will be no inflation going forward.

Whenever I see a market screaming something which such certainty, my contrarian “blood in the streets” instincts begin to kick in. As I recently wrote in an article on silver, it is true that we haven’t seen significant inflation in some time. It’s also true that any real tapering of QE will depress the inflation equation further.

Yet from a contrarian perspective, I think it’s wise to ask ourselves the following question: If we are going to see a continuation of rising interest rates (i.e., rising bond yields) because of Fed tapering, an action that would be taken by the Fed ostensibly because of an improved economy, then won’t that combination eventually lead to inflation?

According to Jeffrey DeMaso, director of research at Advisor Investments, investors are basically leaving the TIPS trade at precisely the wrong time. As quoted in a recent article in Barron’s, DeMaso said: “Do the investors who expected QE to lead to inflation now believe the Fed will be able to manage their exit strategy perfectly? Shouldn’t stronger economic growth put us at greater risk for inflation?” DeMaso added, “TIPS are more attractive today than they were several months ago — inflation looks to be a greater risk today, the hurdles for inflation protection are lower, hence that protection is cheaper.”

It’s hard to see why so many market pundits are discounting for higher interest rates but basically ignoring the potential of future inflation. At some point, economic reality will set in, and we will see the inflation boogeyman come out of hiding. When that happens, a position in this TIPS fund here at multi-year lows could be rewarded handsomely.

The way I see it, there aren’t a lot of places to find good trading values right now aside from strong momentum plays. Yet like silver, I do think the inflation trade is a segment where there is value, and that’s why I think a small position in TIP could pay off big over the next six months and possibly beyond.

Action to Take –>
— Buy TIP at the market price
— Set stop-loss at $105.29, about 8% below the current price
— Set initial price target at $131.61 for a potential 15% gain in six months

This article was originally published at ProfitableTrading.com
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