Treasury Inflation-Protected Securities

Interest rates fluctuate, day by day, hour by hour. That fact makes predicting the future auction yield of a Treasury Inflation-Protected Security pretty difficult, even impossible. But you can guess, and sometimes you can get fairly close, if you watch indicators right up to the morning of the auction.

So in this post I will share some of the data sources I use to check on TIPS yields. And I will use Thursday’s reissue auction of a 5-year TIPS as an example.

1. Check the Treasury’s Daily Real Yield Curve rate

The Treasury posts this each day, and you can track data going back many years. As of Friday, a ‘pure’ 5-year TIPS was yielding -0.19%, up 10 basis points from the day before. Since this is an estimate for a TIPS maturing in a full 5 years, it isn’t perfect for Thursday’s reissue, which has a term of 4 years, 8 months. But it should be close.

Where does the Treasury get this number? Good question. It explains in a footnote that the numbers are “calculated from composites of secondary market quotations obtained by the Federal Reserve Bank of New York.” However they do it, the numbers seem pretty accurate and often signal a future trend.

2. Check the secondary market for TIPS

I use the Wall Street Journal’s data site, which also provides historical data, just use the little calendar icon in the top right corner of the chart. When a TIPS is reopening, like at Thursday’s auction, these numbers are especially helpful, because that TIPS is already trading on the secondary market. Here is last Friday’s close for the TIPS that matures April 2018 and will be reissued Thursday:

As you can see, the yield here, -0.315%, is much lower than the -0.19% projected by the Treasury. So we have a discrepancy, and that would make me think an auction today would produce a number higher than -0.315%. Another helpful item is the bid and asked price – notice the very wide spread. That also indicates a coming change in yield. It also gives you a rough estimate of what you will pay for this TIPS at auction — maybe about $10,132 for $10,000 of value. (Buyers back in April paid dearly, $10,782 for $10,000 of value to get a 0.125% coupon.)

This chart is helpful even for new issues, you can check a TIPS with the closest maturity date. But these numbers aren’t perfect as predictors.

3. Check Bloomberg’s current yields for U.S. government bonds

This is the closest thing you can get to a ‘real-time’ quote, but it also isn’t perfect at predicting an auction price. Right now, at 10 a.m. Monday, it is showing a yield of -0.28% for the 5-year TIPS being auctioned Thursday. It shows a price of 101-29, very close to the bid price shown in the Wall Street Journal’s data. So it looks like the combination of Friday’s Treasury data and the secondary market data did accurately predict a rise in rates this morning.

Another number on this page worth watching is the nominal 10-year Treasury, which is currently trading at a yield of 2.86%. It closed at 2.84% on Friday, so this also shows weakness in the Treasury market.

4. Check the current price of the TIP ETF

I use Yahoo Finance for this. On the morning of the auction, after 9:30 am and before noon when the auction closes to non-competitive bids, check the TIP stock price. If it is down, you are likely to get a higher yield that you expected; if it is up, you are probably going to get a lower yield.

Today, at 10:05 a.m., it is trading at 110.14%, down 0.33%, and confirming weakness in the TIPS market. So we can expect yields to rise slightly if this trend continues.

It’s also fun to check the ETF after the auction announcement at 1 p.m. The TIP market often has a pretty strong reaction to auction results, positive or negative, and you can see the move right at 1 p.m. Here’s an example from July 18, 2013:

And still … it ain’t perfect. Predicting a TIPS yield at auction can make you humble. New issues, especially, are difficult to predict because new inventory is being added to the market. Another factor is Federal Reserve bond buying; you can’t be sure what influence that is having in the market. It’s hard to be a buyer competing with the Fed, and it can use its financial might to set a rate where it wants, when it wants.

But using these data sources can give you a pretty good idea where a TIPS yield is heading on the day of the auction.

‘Headline’ inflation, technically called the Consumer Price Index for All Urban Consumers (CPI-U), increased 0.2% in July on a seasonally adjusted basis, the U.S. Bureau of Labor Statistics reported today. Over the last 12 months, CPI-U has increased 2.0%.

For TIPS and I Bond holders, the important number is the non-seasonally adjusted CPI-U, which is used to adjust the principal of TIPS and set the future interest rate of I Bonds. That number for July was zero – no change – but the last-12-months number remains at 2.0%.

Core inflation, which strips out volatile food and energy prices, was up 0.2% in July, and is up 1.7% over the last 12 months, below the Federal Reserve’s 2.0% target and 2.5% ‘danger’ level. This number, which is closely watched by the Fed, is significant because it  gives the Fed no reason to taper or halt its bond-buying stimulus.

Some highlights from the CPI-U statistics for July:

• Energy was the biggest factor in an otherwise mild inflation month. Gasoline was up a strong 1%, and fuel oil, 1.1%. But utility gas service was down 2.8%.
• Over the last 12 months, gasoline prices are up 5.2%.
• Apparel was up a strong 0.6%, after posting a 0.9% increase in June.
• Medical care services prices continued rising very slowly, up 0.1% in July and only 2.6% over the last 12 months.
• Prices for used cars and trucks fell 0.4% and are down 2.1% over the last 12 months.

And here is the CPI trend over the last 12 months:

What it all means. The July inflation number came in just as predicted, at 2.0% seasonally adjusted. This is a moderate rate that the Federal Reserve can live with, and it wants to see inflation rising above 2.0% a year. So today’s report shouldn’t have much of an effect on the Fed’s bond-buying, and it probably won’t have much effect on TIPS yields.

If you are looking at next Thursday’s auction of a 5-year TIPS reissue, the yield on the secondary market for CUSIP 912828UX6 closed at -0.501%, up a bit since I wrote about it last week. The Treasury’s statistical site is showing a real 5-year yield of -0.38%, substantially higher.

Update at 1:30 p.m.: While Thursday’s inflation number was muted, other economic reports out today gave a rosier economic picture:

•  Initial jobless claims fell by 15,000 last week to 320,000, marking their lowest level since October 2007.
• In a Wednesday report, European GDP rose 0.3% in the second quarter, better than expected and marking an end to European recession.
• In reaction, Treasury yields rose sharply this morning, with the 10-year nominal Treasury hitting 2.77% (the highest rate of the year) and the 10-year TIPS rising to 0.57%, The 5-year TIPS, according to Bloomberg data, rose to -0.40%.

This auction is two weeks away, so I thought I’d take a preliminary peek at it. This will be a reissue of CUSIP 912828UX6, which first auctioned on April 18 with a yield to maturity of -1.311%. This 4-year, 8-month reissue will carry the existing coupon rate of 0.125%.

If you liked it in April … Obviously, a lot has happened since April, with TIPS yields rising dramatically for two reasons: 1) the Federal Reserve’s announced plan to begin tapering its Treasury-buying program if the economy continues improving, and 2) a trend of sluggish U.S. inflation, which makes TIPS less attractive to investors.

Here’s a recap of 5-year TIPS yields in 2013, demonstrating that even as nominal Treasury rates rose, and even after a recent decline in TIPS yields, TIPS have become less expensive compared to a traditional Treasury:

Although you see negative yields in this list for the TIPS, that negative rate is offset by inflation. The base principal of a TIPS increases with inflation until maturity. That is why the breakeven rate is so important. Right now, a 5-year TIPS will outperform a 5-year Treasury if inflation averages more than 1.93% over the next 5 years.

Inflation over the last five years has averaged 1.3%, but that was only the second time it has been under 2.0% in a five-year period in the last 50 years. See a chart.

As of Wednesday,  CUSIP 912828UX6 was trading on the secondary market at -0.670%, a little worse than the Treasury estimate listed above for a full 5-year TIPS.

Because it carries a coupon rate of 0.125%, buyers will be ‘paying up’ to get the resulting negative yield. My guess currently is about $10,325 for $10,000 of value, down from about $10,782 when the TIPS was first auctioned.

Danger in paying up. While your principal is guaranteed at maturity, the amount you pay up is not guaranteed. If we see 5 years of deflation, a buyer paying $10,325 this month will get $10,000 back at maturity, along with earning 01.25%. I consider this highly unlikely, but it is worth noting.

Alternatives? There is no doubt that the US Savings I Bond is superior to a 5-year TIPS. It pays the rate of inflation, minus nothing, has rock-solid deflation protection and is tax-deferred until maturity, which can be anywhere (without penalty) from 5 years to 30 years. The hitch is that you can buy only $10,000 per person per year. (You can also get additional paper I Bonds in lieu of income tax refund.)

What about insured bank CDs? My local credit union is paying 1.30% on 5-year CD, less than a 5-year Treasury. You can shop around and find better rates, possibly up to 2.0%, which would push the breakeven rate up to 2.55%. A bank CD with a high rate is pretty competitive, if you can find those ‘lofty’ rates.

Trend is working against buyers. The 5-year TIPS yield has dropped 10 basis points since Aug. 1, and 28 basis points since July 5. It’s a trend worth watching. While I would like to add this TIPS to my bond ladder, I am going to keep an eye on that yield.

A lot can happen in two weeks.

I guess the Ben Bernanke euphoria wore off overnight, but just for bonds. The stock market took off, with both the Dow average and S&P 500 index setting record highs. (NOT adjusted for inflation, as my frequent reader Ed will certainly note.)

TIPS and the overall Treasury market took a minor beating. The 10-year nominal Treasury closed at 2.74%, up 14 basis points in a day and setting the highest yield of the year. The 10-year TIPS closed at 0.48%, up 10 basis points from Wednesday, but still off the year’s high of 0.66%. The 10-year inflation breakeven point nudged up to 2.26%, which I guess qualifies as ‘neutral’ on the expensive/inexpensive meter.

So what happened? The biggest news of the day was the report on unemployment claims, which was good news. From the Reuters report:

Data on weekly U.S. initial jobless claims and national manufacturing came in better than expected. The Institute for Supply Management index of national factory activity for July rose to its highest level since June 2011.

“The talk we’ve been hearing that the second half is going to be better than the first. We saw some follow-through on that … ,” said Brian Amidei, managing director at HighTower Advisors in Palm Desert, California.

The Federal Reserve has two data points it is watching to determine whether to continue its bond buying, which suppresses TIPS yields: 1) the U.S. inflation rate, and 2) the U.S. unemployment rate. If the unemployment rate falls below 7% and inflation rises above 2%, the Fed has a open door to shut down bond buying.

Both 1 and 2 appear likely in coming months. The stock market loves an improving economy and can deal with rising interest rates (to a point). The Treasury bond market has no fear of a bad economy, but gets very freaked out by rising interest rates.

Good news in the economy is going to cause TIPS yields to rise.

Update on this month’s 5-year TIPS reissue. The 5-year TIPS closed today at -0.45%, still well below its high for the year of -0.27%. We could see some movement toward that -0.27% ahead of the auction Thursday, Aug. 22, but right now I am guessing  we won’t go higher.

No surprises here. The Federal Reserve noted that the economy is growing slowly and its strategy of near-zero interest rates and monthly bond buying will continue. I’ll just quote today’s Federal Reserve statement on the most predictable news of the week:

• Evidence of slight improvement. (E)conomic activity expanded at a modest pace during the first half of the year. Labor market conditions have shown further improvement in recent months, on balance, but the unemployment rate remains elevated. … The Committee expects that, with appropriate policy accommodation, economic growth will pick up from its recent pace and the unemployment rate will gradually decline …
  
• Inflation remains too low. Partly reflecting transitory influences, inflation has been running below the Committee’s longer-run objective, but longer-term inflation expectations have remained stable. … The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, but it anticipates that inflation will move back toward its objective over the medium term.
  
• Congress, you dogs. (F)iscal policy is restraining economic growth.
• The result, stay the course. To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month.
• The not-so-secret strategy. Taken together, these actions should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.
• But, just in case you wondered … The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes.

What it means. 

1. The Federal Reserve desperately wants the U.S. inflation rate to rise above 2% (it is currently running at 1.8%). It is practically guaranteeing inflation higher than 2%.
2. The Fed isn’t pleased by the currently slow rate of economic growth (it again took a swipe at Congress for tight fiscal policy). Second-quarter GDP came in today at 1.7%,  better than expectations. Not enough, says the Fed.
3. Most importantly, after having spooked both the stock and bond markets with talk of ‘tapering’ its bond buying in early July, the Fed is going to continue sweet-talking the markets that bond buying will continue, until some possibly unreachable date in the future. The Fed wants stock prices higher and bond yields lower. Period.

And for TIPS?

Today’s chart for the TIP ETF says it all (the Federal Reserve statement was announced at 2 pm EDT):

While TIPS yields have reached ‘barely tolerable’ levels in recent weeks, buyers have also been fighting the Fed, which seems determined to keep yields very low. But I do think the Fed really doesn’t want a bond bubble, so it has set off a bit of confusion about where rates are headed. That may be able to keep rates positive, at least for a 10-year TIPS.

Not that much really happened today, no big deal. I’d keep an eye on the 10-year nominal Treasury, which closed today at 2.60%. Where it goes, the 10-year TIPS, which closed the day at 0.38%, will follow.

Remember … Eternal quantitative easing drives TIPS yields down, and prices up. The 10-year TIPS breakeven rate widened out today to 2.22%, up from yesterday’s 2.14%. That makes TIPS more expensive.