Treasury Inflation-Protected Securities

Like I always say .. a lot can happen in a week. Or even days. What was shaping up to be a very attractive auction today – creating a 9-year, 10-month Treasury Inflation-Protected Security – has turned a bit sour.

On Wednesday, the August inflation report became a deflation report, with prices dipping 0.1% for the month. Deflation isn’t a good thing in the TIPS market, and that sent the TIP ETF dipping below my long-watched $110 level. The yield on a 10-year TIPS hit 0.73%, highest of the year.

But  the deflation news bolstered spirits for the Federal Reserve’s interest rate ‘doves.’ On Thursday, the Federal Reserve put off raising short-term interest rates, which have been set at near-zero for nearly seven years. And the TIPS market cheered. The yield on a 10-year TIPS dropped 10 basis points, to 0.63%.

And now it’s Friday, auction day. Let’s see where we stand at 9:45 a.m.:

• Today’s auction is a reopening of CUSIP 912828XL9, with a coupon rate of 0.375%. Bloomberg’s Current Yields page shows it is trading this morning with real yield to maturity of 0.58% and a price of about $98 for $100 of value.
• The Wall Street Journal’s Closing Prices page shows this TIPS ended Thursday with yield of 0.604% and a price around $97.50.
• The TIP ETF opened up this morning — it is up more than 1% in two days. That means lower yields.

That one day delay – costly for investors, great for the Treasury.

If this TIPS had been auctioned at its normal time, closing at 1 p.m. Thursday, it would have generated a real yield of about 0.75% – the highest number in more than four years of 9- to 10-year TIPS auctions.

Instead, it will now go off somewhere around 0.58% — 18 basis points lower. It will cost investors more than 1% more than it would have 24 hours ago. This TIPS closed Wednesday with a price of about $96.69. Today’s price could be right around $98.

Amazing.

Although I already have a small investment in CUSIP 912828XL9, I’ll be skipping this auction. This TIPS will be reopened one more time – in November.

The least surprising news of the week beeped on my telephone as I waited in line to check out at Costco Thursday afternoon. News alert: ‘Fed stands pat on interest rates.’

A better headline would have been: ‘Fed thumbs its nose again at savers.’ And so we will continue for a few months more, at least, of very-close-to-zero interest rates on our savings. Predictable, because the Fed clearly doesn’t have the courage to lift its ‘extraordinary measures’ that have continued nearly seven years.

Here was the USA Today headline on Dec. 17, 2008: ‘Fed cuts interest rates to near zero to combat economic recession‘. It’s an interesting story to look back on, because at the time it seemed to be a remarkable move. Here are some quotes:

The dramatic move sent stocks soaring as the Dow Jones industrial average surged 4.2% and broader indexes jumped more than 5% …

“The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability,” the Fed said. “In particular, the committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.”

The Dow rose 359.61 to 8,924.14 … “All in all, it’s good news for stocks,” said Jack Ablin, chief investment officer at Harris Private Bank. “It gave the market a little bit more than they expected.”

It worked, right? In the ensuing seven years, the stock market has doubled, the unemployment rate has dropped from 10.1% in October 2009 to 5.1% today. Economic growth – measured by GDP – has risen from -0.92%  in December 2008 to 3.91% as of March 2015.

All these things indicate a pretty ordinary – possibly even healthy – economy. And yet the extraordinary measures continue.

The one factor in the Fed’s favor is overall inflation, which has dropped to 0.2% over the last 12 months as gas prices have fallen dramatically. But when you strip out gas and food, inflation has been running at 1.8%, still mild but close to an acceptable target.

“Inflation is anticipated to remain near its recent low level in the near term but the Committee expects inflation to rise gradually toward 2 percent over the medium term,” the Fed said in its minutes released today.

And then the Fed placed thumb to nose and wagged: “To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate.”

The TIPS market reacted with glee, driving the TIP ETF up 0.78% for the day, closing at $110.87, one day after dipping below the magic $110 number. The Treasury’s estimate of the real yield for a 10-year TIPS dropped 10 basis points, from 0.73% on Wednesday to 0.63% today.

All of this comes on the eve of a delayed auction for the reopening of a 10-year TIPS. The Treasury is going to save a lot of money because of that one-day delay.

Sigh.

The Consumer Price Index for All Urban Consumers (CPI-U) decreased 0.1% in August on a seasonally adjusted basis, the U.S. Bureau of Labor Statistics reported today. Over the last 12 months, the all-items index rose 0.2%.

This wasn’t unexpected, although the consensus according to Barrons was a 0.0% number. Lower gasoline prices (down 4.1% in the month) and fuel oil (down 8.1%) were the cause of August’s decline. The overall energy index is down 15.1% over the last 12 months.

Other items showed price increases: Food was up 0.2% in the month; apparel, 0.3%; and medical care commodities, up 0.3%.

Core inflation, which strips out food and energy, increased 0.1% in August and is up 1.8% over the last 12 months. While core inflation remains mild, it is approaching the Federal Reserve’s target of 2.0% annual inflation.

Holders of TIPS and I Bonds are also interested in non-seasonally adjusted inflation, which is used to set future interest rates on I Bonds and to adjust the principal balance on TIPS. In August, the CPI-U inflation index was set at 238.316, down 0.14% for the month and up 2.0% over the last 12 months.

For holders of I Bonds, these numbers are significant. With one month remaining in the March to September adjustment period, inflation is up 0.93%, which would result in a new inflation-adjusted rate of 1.86% (annualized) on Nov. 1. That would be up from the current number of -1.60%. It’s possible we could also see the fixed rate rise above 0.0% on Nov. 1.

Keep  some cash available, just in case. To view the long-term trends, visit my Tracking Inflation and I Bonds page.

Wisconsin

I was vacationing in peaceful Wisconsin last week and the Treasury’s awfully early and rather strange auction announcement slipped right past me. These usually come around the 15th of the month, but not this time. No, the Treasury wants to pile a TIPS auction right after the Federal Reserve meeting this week – a meeting where the Fed could decide to raise short-term interest rates (very gently, I am sure, if at all).

Note the weirdness. The Fed decision will come Thursday afternoon. Normally, TIPS auctions close at 1 p.m. on Thursdays, but not this time. This auction will be Friday, Sept. 18, and will close at noon. Non-competitive bids must be placed by 11 a.m. Friday.

This is CUSIP 912828XL9, which originally auctioned on July 23 with a coupon rate of 0.375% and a real yield to maturity of 0.491%. Friday’s auction will create a 9-year, 10-month Treasury Inflation-Protected Security.

Friday’s auction is going to be very interesting. This TIPS is going to go off at a discount, but how much? Things are going to be volatile. We are going to get an August inflation report on Wednesday (the consensus is for 0.0%) and then a Fed decision Thursday.

Here is where things stand right now:

• Because this TIPS trades on the secondary market, you can check real-time quotes at Bloomberg’s Current Yields page. At 5 p.m. Tuesday, Bloomberg is showing a real yield to maturity of 0.70% and a price of about $96.87 for $100 of par value.
• The Wall Street Journal’s Closing Prices page shows that this TIPS closed Tuesday with a yield of 0.693% and a bid price of about $96.69 for $100 of value.
• The Treasury’s Real Yields Curve page estimates a full-term 10-year TIPS would have closed Tuesday with a yield to maturity of 0.72%, very close to the Bloomberg number.

If this TIPS auctions with a real yield above 0.70%, it would be the first 9- to 10-year TIPS auction to close that high since May 2011. There have been 25 auctions since then!

TIPS yields have been rising steadily in the last few weeks, and the TIP ETF has been feeling the pain (prices drop when yields rise). It closed today at $110.06, down 0.6% for the day and about 2.2% in the last 90 days. Demand for TIPS appears weak as we head toward Friday’s auction. You can see the trend in this three-month chart, which compares the TIP ETF in blue, versus the IEI (intermediate Treasury ETF) in red. TIPS have suffered while intermediate Treasurys have barely budged:

TIPS versus nominal Treasurys. With a nominal 10-year Treasury closing today at
2.28% and a 10-year TIPS at 0.72%, you get an inflation breakeven rate of 1.56%, which I consider very attractive. In this chart, you can see breakeven rates hitting lows for the last five years:

Conclusion. Amid all this chaos, a very attractive TIPS auction could be setting up for Friday. If yields hold above 0.7%, demand might return to the TIPS market. People who follow this blog know that I have said many times that the TIP ETF dropping to below $110 would mark a possible ‘buy’ for TIPS and TIPS mutual funds. We are getting very close.

Until then, study this chart of all 9- to 10-year TIPS auctions. I’ll be posting on Friday with a pre-auction update and then after noon, the auction results.

As stock markets wavered violently over the last week, the market for Treasury Inflation-Protected Securities has been remarkably sedate, and surprisingly, there is no apparent demand for TIPS as a ‘safe harbor.’

This chart shows the 5-day market results for TIPS, represented by the TIP ETF in blue, versus the overall stock market, represented by the SPY ETF in red:

This is surprising because TIPS for years have been the safe harbor investment of choice: 1) for safety, and 2) for inflation protection against possible monetary moves to stimulate the markets.

Remember the last correction? It had been more than four years since the stock market suffered a decline of more than 10%. In fact, the last stock market correction – which began in July 2011 – was the starting point for an explosion in the value of TIPS, pushing yields negative to inflation for years. I wrote about this in my April 25, 2103, article titled, ‘The TIPS earthquake: When did it happen, and why?’

That article included this chart, showing the huge move up for Treasurys and TIPS which began at the exact moment the stock market plummeted (oddly enough, in reaction to Standard & Poors downgrading US Treasurys):

You can see in that chart that TIPS greatly outperformed the overall bond market for the remainder of 2011 (represented by the AGG ETF in red). But this time – the 2015 correction – that isn’t happening. As the stock market plummeted this week, TIPS values actually declined. And this chart shows that TIPS aren’t out-performing the overall bond market:

A final thing to note: TIPS have also been lagging the overall Treasury market, meaning that inflation breakeven rates have been falling over the last week. That happens when TIPS yields rise more than Treasury yields. Here are the numbers:

Conclusion. What can we take from this? 1) That the market does not fear inflation and does not expect the Federal Reserve to rush in with economic stimulus, 2) That the market is viewing the current stock market volatility as a correction and not the beginning of a major bear market, and 3) that the market still believes higher interest rates are coming, if not in 2015, then early in 2016.

TIPS are not going to be the ‘safe harbor’ investment in 2015. If yields continue to climb, we could see buying opportunities.