Treasury Inflation-Protected Securities

Wednesday was certainly an interesting auction’s eve. On the day before the Treasury is reopening CUSIP 912828B25 – a 10-year Treasury Inflation-Protected Security – at auction, the Federal Reserve today issued a statement that certainly said nothing dire … but the market reacted.

The TIPS market was shaken when the statement was released at 2 p.m., as you can see from this chart, showing the one-day price of the TIP ETF, which holds a broad range of maturities:

So what did the Fed say? The big news, as reported in this Wall Street Journal report, is that the Fed affirmed that it would continue to hold short-term interest rates low well into the future. It also said, as expected, that it would continue to lower its bond-buying stimulus by $10 billion in April.

All of this appears to be good news for the bond market. So why the hit to TIPS, which were slammed harder that the overall bond market, the overall Treasury market, and even harder than long-term Treasuries?

Michael Ashton, who writes the E-piphany blog focusing on inflation, offers this explanation:

TIPS were mainly under pressure because there is an auction scheduled for tomorrow and it was dangerous to set up prior to the Fed meeting, not because there was something secretly hawkish about the Fed’s statement. Indeed, they took pains to say that “a highly accommodative stance of monetary policy remains appropriate” …

If you are searching for secret code words from the Fed, you can read its full statement. In very brief summary, it says:

1. The economy has slowed (slightly) because of the harsh winter.
2. Inflation is running below the Fed’s long-term objective. “The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance.”
3. The Fed will continue tapering its bond-buying stimulus program in April, but it will still be buying $50 billion in bonds that month.
4. The Fed said it will continue to keep short-term interest rates very low, noting “that a highly accommodative stance of monetary policy remains appropriate.”
5. And well, forget about the numbers: “Even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.”

So there you go. If anything, this Fed policy is encouraging – practically begging for – higher inflation, and that should cause demand for TIPS to rise and yields fall. But the opposite happened Wednesday.

It will be interesting to see what happens Thursday morning. If TIPS continue on a sharp decline – meaning yields rise – Thursday’s auction could get a lot more desirable.

As of the market close Wednesday, CUSIP 912828B25 (the TIPS being reopened Thursday) was trading on the secondary market with a yield of 0.571%, substantially higher than Wednesday’s close of 0.480%, but still well below the 0.661% that this same TIPS drew at its original auction Jan. 23.

Keep an eye out in the morning.

Later today, the U.S. Treasury will formally announce it will reopen CUSIP 912828B25, a 10-year Treasury Inflation-Protected Security, in an auction on Thursday, March 20. This TIPS originally auctioned Jan. 23, 2014, with  a coupon rate of 0.625% and a yield to maturity of 0.661%, plus inflation.

Update: Here’s the announcement.

So, what can we expect from this 9-year, 10-month TIPS?  If the auction were today, the yield to maturity might be around 0.55%, a drop of 7 basis points since the January auction. That means buyers would have to pay up a little to snag this TIPS, around $100.30 for  $100 of value.

But a lot can happen in a week. Here are some data sources to check before the auction:

• The Treasury’s Daily Real Yield Curve Rates, which right now are indicating a yield of 0.54% for a 10-year TIPS.
• Bloomberg’s Current Yields, which reflects current trading but can be a little misleading. At this moment, it shows CUSIP 912828B25 trading at 0.55%.
• The Wall Street Journal’s closing price list for TIPS, which shows that the TIPS maturing 2024 Jan 15 closed Wednesday at 0.523%.
• I’d also recommend using the Treasury’s Yield Curve site to track the yield of the nominal 10-year Treasury, which is currently at 2.73%. The TIPS yield is likely to rise and fall with that number over the next week.

If next Thursday’s auction yield fails to exceed 0.661%, it will break a string of eight consecutive 9- or 10-year TIPS auctions that have resulted in a higher yield. Here is a history of 10-year TIPS auctions going back to 2009:

Although bond yields were expected to rise in 2014, the opposite has happened, thanks to some shakiness in the stock market and worries over Russia’s incursion into Crimea. All Treasurys, including TIPS, benefit with the ‘flight to safety’ that inevitably follows stock-market hiccups. The TIP ETF is up almost 2% since Jan. 1, even as inflation remains tame.

It’s also significant that TIPS have been out-performing Treasuries of similar terms. Take a look at this year-to-date chart for the TIP ETF versus IEI, an ETF holding intermediate-term Treasuries and having a similar duration:

When you see this happen, it means the inflation breakeven rate is climbing, and TIPS are getting more expensive versus traditional Treasuries.

If next Thursday’s auction goes off at 0.55%, it would create an inflation breakeven rate of 2.18%, versus 2.12% when the TIPS first auctioned in January. Still on the relatively cheap side, but keep an eye on the 10-year Treasury over the next week.

Look who’s happy.

The Wall Street Journal headline today seems like great news: ‘U.S. Household Net Worth Hits Record High.‘ It is good news for those sharing in the prosperity. But the article’s sub-headline sheds light on the complexity: ‘Surging Stock Market and Rising Home Values Deliver Benefits, Especially for Affluent.‘

The Federal Reserve issued a report Thursday noting that the net worth of U.S. households  rose 14% last year, to $80.7 trillion, the highest on record. Even adjusted for inflation, U.S. household net worth – the value of homes, stocks and other assets minus debts and other liabilities – hit a record.

Great news, right? Here’s the dark side, from the Journal report:

But the rebound, while powerful, has been tilted in a way that limits the upside for the broader U.S. economy and is increasingly leaving behind many middle- and lower-income Americans.

“Wealth inequality…has increased over time,” said William Emmons, an economist at the Federal Reserve Bank of St. Louis. “So, there seems to be a disconnect: There are big wealth gains, but not much follow-through on consumer spending.” …

Younger families in particular continue to lag behind in the wealth recovery. The average young family—led by someone under 40—has recovered only about a third of the wealth it lost during the crisis and recession ….  By contrast, the average wealth of middle-aged and older families has recovered to roughly precrisis levels.

I write a blog about Treasury Inflation-Protected Securities and I Bonds, two investments that focus on capital preservation, and therefore are targeted at upper middle-class and wealthy investors. You won’t get rich investing in TIPS and I Bonds, but a lot of rich people invest in them. Why? Because they are already rich.

I won’t admit to being rich (nobody does, right?) but I do know that what wealth I have came because I had the good fortune to be born in 1953, at a time of great economic expansion in the United States. I was able to finish college without debt. I was able to get a good job, right away. My wife and I were able to save money during the greatest bull market in U.S. history.  We were able to buy an affordable house and watch its value climb. We were able to accumulate enough assets to be more conservatively invested during the dual market crashes of the 2000s.

Yes, we saved diligently, but mostly … we were lucky.

Young families – people younger than 40 – face a much different picture today.  Many are burdened with heavy college debt. Many have had trouble finding jobs matching their skills. Their jobs no longer offer pensions, and their pay raises barely match inflation. They pay more for health care. Their investments have been hit by at least one major market crash, maybe two.

These families don’t have large stock market assets – how could they? – and many don’t own homes. So their net worth is not rising along with older Americans’. They can’t join the party.

The Federal Reserve of St. Louis took a look at these numbers and wrote a report titled,  ‘Housing Crash Continues to Overshadow Young Families’ Balance Sheets.‘  It includes this chart showing how younger families are not gaining ground:

The Federal Reserve study noted:

The main reason young families’ balance-sheet recovery lags is the recent housing crash and its lingering effects. The homeownership rate among younger families has plunged. … The house-price gains that have helped mainly older families to rebuild homeowners’ equity have been overshadowed among younger families by the ongoing retreat from homeownership.

This ‘two Americas’ theme isn’t new, but it is interesting to see it framed as young vs. old. As these young families age, will they be able to accumulate assets to build significant net worth?

I worry about that.

You might ask: ‘How are you going to define ‘normal’? Good point. In the financial world, the going price for anything might be called the ‘normal’ price, set by free markets. But in the case of Treasury Inflation-Protected Securities, normal is very hard to define.

So, for today only, I am going to define ‘normal’ to mean ‘acceptable.’ In other words, attractive to buyers, a sensible investment, and in line with historical trends. Today, with a 10-year TIPS yielding about 0.52% above inflation, I don’t think we are there yet.

I have tried in the past to project a ‘sensible’ yield for a 10-year TIPS, and I came up with a yield of about 1.76%, plus inflation. We won’t be seeing that anytime soon, but read my analysis to see why TIPS yields will eventually return to that level, and probably higher.

So for today, I decided to declare the first auctions of 2011 – for 5-, 10-, and 30-year TIPS, to be about as ‘normal’ as we can expect to see in the next two years.

Why early 2011? The TIPS and Treasury markets dramatically changed in mid-2011, a fact I detailed in this post: The TIPS earthquake: When did it happen, and why? It’s strange, but the factor that triggered this upheaval was the crushing failure of Congress to address runaway government spending and spiraling deficits. Eventually, Standard & Poors downgraded U.S. debt – and the result was that U.S. debt skyrocketed in value. As weird as that seems, that’s the way it happened.

(True, it wasn’t the S&P downgrade of U.S debt that directly resulted in soaring Treasurys. But the fiscal crisis and resulting downgrade caused the stock market to plummet and suddenly the U.S. economy looked extremely dire. The Federal Reserve responded with an aggressive bond-buying stimulus program. That raised fears of inflation and that directly caused TIPS to soar, along with the stock market.)

I started this blog in April 2011 and at the time TIPS were as boring and conservative an investment as exists on Earth. Within a few weeks, I read a commentary that said: “The only reason to buy TIPS is for the capital gain.” I was horrified! No, TIPS are conservative! Not for trading! But the commentator was totally correct. TIPS were about to launch into massively lower yields and higher prices.

So let’s look back to the first auctions of 2011, before this turmoil began, in search of something ‘normal.’

• Jan. 20, 2011. A new 10-year TIPS, CUSIP 912828PP9, auctioned with a yield to maturity of 1.17% and a coupon rate of 1.125%. Since that date, no 9-to 10-year TIPS auction has generated a yield above 1%. The highest yield since then was 0.92% for the reopening of this same TIPS on March 24, 2011.
• Feb. 17, 2011. A new 30-year TIPS, CUSIP 912810QP6, auctioned with a yield to maturity of 2.19% and a coupon rate of 2.125%. The highest yield since that date for any 29- to 30-year TIPS was 1.42% in June 2013 for a reopening of CUSIP 912810RA8.
• April 21, 2011. A new 5-year TIPS, CUSIP 912828QD5, auctioned with a yield to maturity of -0.18% and a coupon rate of 0.125%. At the time, this auction made headlines: BUYERS ACCEPT NEGATIVE INTEREST ON TIPS! Several financial columnists derided buyers as fools. I was a buyer, and I didn’t feel foolish. Since that date, the best yield on any 4- to 5-year TIPS auction was -0.13% for a reopening of CUSIP 912828UX6 on Aug. 22, 2013, another auction where I was a buyer.

To recap, this is about as normal as we can expect in 2014 and possibly well into 2015:

• 5-year TIPS at -0.18%, plus inflation. The current yield is -0.25%
• 10-year TIPS at 1.17%, plus inflation. The current yield is 0.52%
• 30-year TIPS at 2.19%, plus inflation. The current yield is 1.35%

We have a long way to go, except for the short-term TIPS. If you think a move that large isn’t possible, I will close with this chart of all TIPS auctions in that momentous year of 2011. Study it: