But beware: Real yields are volatile; even hour to hour
By David Enna, Tipswatch.com
The Treasury on Thursday will auction $17 billion in a new 10-year TIPS, CUSIP 91282CEZ0, and this offering should be somewhat historic, for several reasons:
- That $17 billion number is the highest auction amount in history for a 10-year TIPS opening or reopening. The last auction of a new 10-year, on January 20, was for $16 billion. A year before, on Jan. 21, 2021, the size was $15 billion.
- So the amount is increasing even as the Federal Reserve is reducing its balance sheet of TIPS and other Treasurys, meaning it won’t be rolling over its current holdings. The Treasury is trusting that investor demand will pick up the slack.
- The Treasury on Friday estimated the real yield of a 10-year TIPS at 0.57%, which would be the highest real yield at auction for this term since an auction on March 20, 2020, in the midst of pandemic panic.
- Unfortunately, that Treasury estimate has fallen 15 basis points in the last week. This is the sort of volatility we are seeing in the Treasury market, every week, as the market reacts to potential Fed actions to combat inflation.
- If the auctioned real yield holds above 0.50%, the coupon rate for this TIPS will be set at 0.50%, or possibly even 0.625% if the real yield can break through to 0.625% or higher. A coupon rate of 0.50% would be highest for a new TIPS since an auction on Jan. 17, 2019.
Watching market coverage this week, I was catching the drift from “experts” that the Fed will raise short-term interest rates, probably 75 basis points, later this month and then again — possibly 50 basis points? — in September and then go quiet, waiting to see how the economy reacts. The current Federal Funds Rate is in the range of 1.50% to 1.75%, but effectively 1.75%. An increase of 75 basis points brings it to 2.50% and another 50 to 3.00%.
At this point, short-term Treasury bills are already pricing for those increases, with the 13-week Treasury yielding 2.37% and the 1 year at 3.12%. But beyond those short-term rates, the yield curve goes flat, with the 5-year Treasury note at 3.05%, the 10 year at 2.93% and the 30 year at 3.10%. That’s not good news for investors in a 10-year TIPS, because lower nominal yields will drag real yields lower, most of the time.
All this could change next week, as the bond market slushes around based on the latest “theory” of the Fed’s future actions and the effects on the U.S. economy. Inflation expectations have also been sliding lower, even after last week’s dreary June inflation report, which set annual U.S. inflation at 9.1%.
Definition: The “real yield” of a TIPS is its yield above or below official future U.S. inflation, over the term of the TIPS. So a real yield of 0.57% means an investment in this TIPS will exceed U.S. inflation by 0.57% for 10 years.
I tend to believe that if inflation continues at a pace around 4% to 5%, which seems likely for many months, real yields will have to rise as the Fed continues stepping on the brakes. So is a 10-year TIPS yielding 0.57% attractive? I’d say yes, even knowing future rates could be higher. Here is a history of the 10-year real yield from 2010 to today:
Note that we have now reached the mid-point of 10-year real yields during the Fed’s last tightening cycle, which peaked in late 2018. At that time, the 10-year real yield rose to about 1.15%. Also at that time, U.S. inflation was running at 2.2%, far below today’s 9.1%. The Fed has a long way to go before it can end the current tightening cycle.
Pricing. If the real yield of this TIPS holds above 0.50%, the coupon rate will be 0.50% and the unadjusted price should be a little less than par value. However, this brand new TIPS will have an inflation index of 1.00495 on the settlement date of July 29. Why? Because non-seasonally adjusted inflation ran at 1.1% in May, so the half-month inflation accrual for this TIPS is 0.49% on the settlement date.
The inflation accrual means that investors could be paying an adjusted price of about $100.49 for about $100.49 of value, with accrued inflation. But the price will be a bit lower because the real yield will end up being higher than the coupon rate. It could balance out, but will probably be a bit above $100.00.
Inflation breakeven rate
With a 10-year Treasury note yielding 2.93% at Friday’s close, this new TIPS would have an inflation breakeven rate of 2.36%, which seems very attractive given current conditions. I’d prefer to invest in a TIPS with a yield exceeding inflation by 0.57%, versus a straight nominal yield of 2.93%.
Here is the trend in the 10-year inflation breakeven rate from 2010 to 2022:
In this chart, note that the current inflation breakeven rate of 2.36% is 20 basis points below the rate in March 2013, when annual inflation was running at a paltry 1.5%. Markets can be weird.
The recent decline in the 10-year inflation breakeven rate indicates that real yields have been holding up better than nominal yields. It also seems to indicate fairly weak demand for TIPS right now. That could be a factor in Thursday’s auction, with the Treasury issuing a record-high $17 billion in a 10-year TIPS.
The dip in real yields last week is a negative for investors, but I’d still be very interested in this TIPS if the real yield can hold above 0.50%. If the economy seriously weakens, we have to be prepared for the Fed to attempt a rescue, as it has continuously done over the last 20+ years. This TIPS isn’t attractive enough to “bet the house,” but a sensible investment seems fine to me.
You can check the Treasury’s real yield estimates for a full-term 10-year TIPS on its Real Yield Curve page. This auction closes at noon Thursday for non-competitive bids, like those made at TreasuryDirect. If you are putting an order in through a brokerage, make sure to place your order Wednesday or very early Thursday, because brokers cut off auction orders before the noon deadline. I’ll report the results after the auction closes at 1 p.m. EDT Thursday.
Here is a recent history of 9- to 10-year TIPS auctions, showing the long string of negative real yields in the aftermath of the pandemic outbreak, beginning in March 2020:
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David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he discusses can be purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.