Treasury Inflation-Protected Securities

• The monthly “headline” inflation number and core inflation for the month and year all came in higher than the consensus forecasts.
• Overall U.S. inflation is being held down by declining gasoline prices, but core inflation is running at 2.1%, which is clearly “moderate” inflation.
• The Federal Reserve probably won’t be swayed by these numbers, and will remain on track to begin lowering short-term interest rates this year.

The Consumer Price Index for All Urban Consumers increased 0.1% in June on a seasonally adjusted basis, the U.S. Bureau of Labor Statistics reported today. Over the last 12 months, “headline” inflation increased 1.6%.

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• Both real and nominal yields have plummeted in 2019, with nominal yields on government debt dipping into the negative in Europe and Asia.
• Returns on I Bonds and EE Bonds still have the same terms that the Treasury set in November 2018 and have now become much more attractive by comparison.
• I Bonds are the best inflation-protected Treasury investment with a maturity under 20 years. EE Bonds are the best nominal Treasury investment with a maturity of 20 or more years.

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• Five-year real yields have dropped nearly 100 basis points in the last six months. That’s a huge move in anticipation of Federal Reserve rate cuts.
• Today’s real yield of 0.152% had to be a disappointment to investors, who also had to pay a premium price for this TIPS.
• The five-year inflation breakeven rate climbed a bit to 1.60%, indicating somewhat stronger demand for inflation protection.

The Treasury’s $15 billion reopening auction of CUSIP 9128286N5 – creating a 4-year, 10-month Treasury Inflation-Protected Security – generated a real yield of 0.152%, dramatically lower than recent auctions of this term.

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• Expect volatility in the Treasury market this week because the Federal Reserve’s Open Market Committee will issue a statement Wednesday, one day before the auction.
• At this point, CUSIP 128286N5 is heading toward a real yield of about 0.35%, 78 basis points below a similar auction in December. Buyers will be paying a premium price.
• A very low inflation breakeven rate of about 1.48% should bring strong market demand for Thursday’s auction.

The U.S. Treasury on Thursday will reopen CUSIP 9128286N5, auctioning $15 billion of a 4-year, 10-month Treasury Inflation-Protected Security. This is an especially interesting auction because it follows six months of rather dramatic yield declines.

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• The Federal Reserve looks likely to begin cutting short-term rates in 2019, possibly as much as 75 basis points over the next year.
• Yields for money market funds and short-term Treasurys will track lower with those rate cuts.
• Inflation-protected investments could perform well in a time of falling rates and steady moderate inflation.

The “glorious” days of getting a 2% return on a very safe, very liquid investment are drawing to a close. Why? The Federal Reserve is on the brink of beginning a series of cuts to its Federal Funds rate, the nation’s key short-term interest rate.

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