Treasury Inflation-Protected Securities

For the first time since December 2008, the Federal Reserve is raising its Federal Funds Rate from zero to a range of 0.25% to 0.50%. If you like, you can read the Fed’s press release detailing its thoughts on the move, which was extremely well telegraphed.

Here is the key paragraph:

The Committee judges that there has been considerable improvement in labor market conditions this year, and it is reasonably confident that inflation will rise, over the medium term, to its 2 percent objective. Given the economic outlook, and recognizing the time it takes for policy actions to affect future economic outcomes, the Committee decided to raise the target range for the federal funds rate to 1/4 to 1/2 percent. The stance of monetary policy remains accommodative after this increase, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation.

In other words, the Fed knows that a base short-term interest rate of 0.25% remains well below the likely rate of inflation in the coming year. And this remains a time of ‘easy money,’ which can continue to spur economic growth.

The Fed also released a chart of projections for the economy and the Federal Funds Rate. It sees inflation rising to 1.6% in 2016, 1.9% in 2017 and 2.0% in 2018 and beyond. And it projects the Federal Funds Rate climbing to 1.4% in 2016, 2.6% in 2017 and 3.3% in 2017. As you can see from the chart, those numbers are slightly lower than the Fed was projecting in September. In actuality, the Fed is saying it expects a ‘normalized’ short-term interest rate of 3.5% when inflation is 2.0% in 2018 and beyond. It’ll take several years – and a steady economy – to see if that is true.

Back in April 2014, I wrote a blog theorizing on where yields for Treasury Inflation-Protected Securities would be heading when the Fed began raising its short-term rate. At the time, I speculated that the rate would rise gradually to 2.5%, which is where the Fed is now projecting it will be in 2017. Here is what I found:

I am going to toss out the high and low numbers in each column, and say that in 2017:

• A 5-year TIPS could be yielding in a range of 0.79% to 0.97%.
• A 10-year TIPS could be yielding in a range of 1.49% to 1.74%.
• No data for 30-year TIPS, so no prediction.

However, one caution: This assumes the Fed will carry out future rate increases. That is certainly not a sure thing.

Checking in on Thursday’s 5-year TIPS reopening

This is a reopening of CUSIP 912828K33, creating a 4-year, 4-month TIPS with a coupon rate of 0.125%, plus inflation.

I am working Thursday morning and I won’t be able to post then, so here we go. If I were buying at this auction – and I definitely might be – I’d want to check these numbers in the morning, because things could be volatile. Non-competitive bids must be placed by noon; the auction closes at 1 p.m.

•  Bloomberg’s Current Yields page shows this TIPS trading with a yield of 0.50% and a price of $98.37 per $100 of value. (It is going at a discount because the yield is higher than the coupon rate.)
• The Wall Street Journal’s Closing Prices page shows this TIPS – which matures in April 2020 – closed Wednesday with a yield of 0.46% and a price around $98.50.
• The Treasury’s Real Yields Curve page estimates that a full-term 5-year TIPS would have yielded 0.55% at the close today. (The yield on a full-term 5-year should be slightly higher than that of a 4-year, 4-month TIPS.)

Thursday morning, check those links and also track the price of the TIP ETF, which closed today at $109.15. If you see the price dropping, that means yields are rising. If the price is rising, yields are dropping.

If this auction generates a yield of 0.4%, it would be highest yield for any 4- to 5-year TIPS at auction since April 2010 – more than five years.

Also, keep in mind that this TIPS will have an inflation index of 1.01563 on the settlement date of Dec. 31. That means buyers will be purchasing about 1.5% of additional principal.

If all stays the same, tomorrow’s auction should net a yield of about 0.48%, which I would consider very attractive. The nominal 5-year Treasury is yielding 1.75%, creating an ultra-low inflation breakeven rate of 1.27%, well below the Fed’s projections. As you can see from this chart of the 5-year breakeven since 2007, this is rare territory:

The Consumer Price Index for All Urban Consumers (CPI-U) was unchanged in November on a seasonally adjusted basis, the U.S. Bureau of Labor Statistics reported today. Over the last 12 months, the all items index increased 0.5%.

Both food prices (down 0.1%) and gas prices (down 2.4) contributed to the flat inflation number. Core inflation – which strips out food and energy – was up 0.2% in November and now has increased 2.0% over the last 12 months. That’s right on the Federal Reserve’s target, although the Fed tracks a slightly different index.

Today’s numbers shouldn’t sidetrack the Federal Reserve’s expected move to slightly raise short-term interest rates after its meetings conclude Wednesday afternoon.

Holders of Treasury Inflation-Protected Securities and I Bonds are also interested in non-seasonally adjusted inflation, which is used to adjust the principal balance on TIPS and set future inflation-adjusted interest rates for I Bonds. In November, the CPI-U inflation index fell to 237.336, down 0.21% from October’s number.

For the current I Bond adjustment period (September 2015 to March 2016) inflation is  running at -0.25%.

I have updated my Tracking Inflation and I Bonds page with these new numbers.

I noticed the TIP ETF – which holds a broad range of Treasury Inflation-Protected Securities – dropped to $109.52 today, down 0.73% for for the day. Here are the Treasury’s estimates of today’s real yields (after inflation) for full-term TIPS versus the beginning of the month.

• 5-year. The real yield stands at 0.49%, up 19 basis points from Dec. 1
• 10-year. The real yield stands at 0.78%, up 20 basis points from Dec. 1.
• 30-year. The real yield stands at 1.32%, up 18 basis points from Dec. 1.

Tomorrow at 8:30 a.m., we’ll get the November inflation report — the consensus estimate is for a zero increase – 0.0%, leaving inflation at about 0.2% over the last 12 months. If the actual number varies highly from 0.0%, it could upset the TIPS market. A deflationary number could stall any move by the Federal Reserve. However, we can be sure the Fed already knows what the number will be, and the Fed has been signaling toward a very small increase in short-term interest rates.

Wednesday afternoon – about 2:15 p.m. ET – we’ll hear the Fed’s decision on short-term rates.

Then, Thursday, we’ll get an auction to reopen a 5-year TIPS, CUSIP 912828K33. It’s possible that this auction will generate a yield somewhere around 0.45% – the highest yield for any 4- to 5-year TIPS in more than five years.

My schedule. I’m working both Wednesday and Thursday and I won’t be able to post much immediately after the inflation report, Fed announcement or the TIPS auction. But I will post another last preview look on the 5-year auction on Wednesday evening.

Here’s the announcement from the US Treasury.

This was the reopening of CUSIP 912828XL9, creating a 9-year, 8-month TIPS with a coupon rate of 0.375%. The resulting real yield to maturity was 0.664%, just barely beating a couple of 2014 auctions to become the highest yield for any 9- to 10-year TIPS auction since May 2011.

Because the yield was higher than the coupon rate, this TIPS auctioned with an adjusted price of $97.64 for $100.34 of value. The adjusted price includes inflation increases since the original auction in July.

Inflation breakeven rate. This 10-year TIPS ended up closing the day with a real yield of 0.65%, compared to a 2.25% yield on a nominal 10-year Treasury. That creates an inflation breakeven rate of 1.60%, which is a bit higher than the norm in recent weeks, indicating that demand is rising for TIPS versus nominal Treasurys. But it is still solidly in the ‘cheap’ range, meaning it is a good buy versus a nominal. If inflation averages more than 1.6% over the next 10 years, this TIPS will outperform the nominal 10-year.

This 5-day chart of the TIP ETF versus IEI (intermediate Treasurys) shows how TIPS have surged against nominal Treasurys. That wasn’t a favorable trend for buyers at today’s auction:

I wasn’t a buyer at today’s auction, although I was watching it with a lot of interest. If the yield looked like it would climb above 0.75%, I might have taken a bite. But I ended up sitting this one out.

December will bring the last TIPS auction of the year, the reopening of a 5-year TIPS on Dec. 17. The current yield of about 0.35% is pretty attractive for a 4-year, 4-month investment. But that yield is pricing in some potential deflation in the near term. It will be one to watch.