Treasury Inflation-Protected Securities

What looked to be a very promising TIPS auction – possibly the most attractive in three years – dimmed considerably Wednesday when the Federal Reserve decided to hold off on tapering its bond-buying economic stimulus program. The result: Both the stock market and Treasury market soared. The announcement came at 2 p.m. and the markets moved in lockstep:

The Federal Reserve action to delay tapering sent both the Treasury markets (shown here as the TIP ETF, in blue) and the stock market (S&P 500, in red) soaring.

Big Bad Ben. Fed Chairman Ben Bernanke is making a habit of putting the hex on TIPS auctions — in fact he put the kibosh on this very same TIPS before it was auctioned on July 18, 2013. Back then my headline was, “10-year TIPS auction: We’ve been jawboned“.  A few weeks before that auction, the yield looked likely to hit 0.65%, but Bernanke stepped in on July 10 to sooth the markets with ‘clarifying’ comments about tapering. The result was a 34 basis-point drop in yield in just 5 days. Thanks a lot, Ben.

So now, what? Today’s TIPS auction is a reissue of CUSIP 912828VM9, creating a 9-year, 10-month TIPS with a coupon rate of rate of 0.375%. Since this TIPS now trades on the secondary market, we can get a pretty good idea of its likely yield, which currently is running about 0.480%. It closed yesterday at 0.494%. While that would be the highest 9- or 10-year auction yield in more than two years, it’s still a bit disappointing. Just two weeks ago, the 10-year TIPS yield stood at 0.92%.

That’s a drop of more than 40 basis points in two weeks. It’s enough to give a buyer pause. And in fact, it’s enough to cause me to skip this auction.

Update: This auction went off with a yield of 0.50%.

In my opinion, the Treasury market just got an artificial jolt. But it won’t last because tapering is coming. When it does, there will be another jolt, causing yields to rise. That is my expectation: Higher yields are coming. That is 100%-guaranteed to happen, as long as … the economy continues to improve, the unemployment rate continues falling and Congress and the president don’t shut down the government.

What exactly did the Fed say?

You can read the statement here. What is remarkable is that the Fed sees very little bad news, but it decided to continue bond-buying at the pace of $1 trillion a year. Here is my summary:

• The economy. “Economic activity has been expanding at a moderate pace.”
• Unemployment. “Some indicators of labor market conditions have shown further improvement in recent months, but the unemployment rate remains elevated.”
• Inflation. “Apart from fluctuations due to changes in energy prices, 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.”
• The future. “The Committee expects that, with appropriate policy accommodation, economic growth will pick up from its recent pace and the unemployment rate will gradually decline.”
• Tapering? Not yet. “The Committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases. Accordingly, 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.”
• Hidden message for buyers at today’s TIPS auction? “Taken together, these actions should maintain downward pressure on longer-term interest rates …”

Message received.

The Federal Reserve blinked today and delayed any move to cut back on its bond-buying stimulus. The immediate reaction in the TIPS market was a plunge in yield. This development puts in turmoil the likely yield for Thursday’s auction of a reissue of a 10-year Treasury Inflation-Protected Security, CUSIP 912828VM9.

The yield on a nominal 10-year Treasury immediately dropped about 10 basis points. At 2:30 p.m., Bloomberg’s real-time data for a 10-year TIPS show a yield of 0.54%, down 16 basis points from yesterday’s close of 0.70%.

The dramatic move is shown in this inter-day chart for the TIP ETF:

More details to come as we get more information.

Beautiful Fort Anne, built in 1797 to protect the harbor of Annapolis Royal, Nova Scotia.

I’ve been away on vacation in Nova Scotia the last two weeks, away from a computer and (usually) far from e-mail or business news. So we have some catching up to do … plus there is a 10-year TIPS reissue auction coming up this week … and a new inflation report.

Bump in yields

When I left on August 30, the 10-year TIPS yield stood at 0.68%, plus inflation. Today it is about 0.76%, so it’s seen a bit of a boost. But within those two weeks, on September 5, it high a multi-year high of 0.92%. The inflation breakeven rate for a 10-year TIPS today stands at 2.12%, about where it was two weeks ago.

Today’s inflation report

The U.S. ‘headline’ inflation rate – technically known as the seasonally-adjusted Consumer Price Index for All Urban Consumers (CPI-U) – increased just 0.1% in August and is up a meager 1.5% over the last 12 months. The weak number was primarily caused by a 0.1% drop in the price of gasoline, and a 0.3% decline in energy overall. Food was up just 0.1%. Medical care services, however, were up a sharp 0.7%.

Holders of TIPS and I Bonds care most about the non-seasonally adjusted increase, which is used to adjust the principal on TIPS and set future rates for I Bonds. That increase was also 0.1% in August, and 1.5% over the last 12 months.

‘Core’ inflation, which strips out energy and food, was also up 0.1% in August and up 1.8% over the last 12 months, below the Federal Reserve’s target of 2%.

Today’s inflation report could tip the balance to cause the Federal Reserve to back away from plans to taper its QE3 purchases of Treasuries. That announcement could come Wednesday after a Federal Reserve meeting.

The early reaction to these numbers has TIPS yields falling today, with the 10-year TIPS trading at 0.70%, down 6 basis points from yesterday. The TIP ETF is up about 0.25% in early trading.

10-year TIPS reissue will auction Thursday

This is a reissue of CUSIP 912828VM9, which first auctioned July 18, 2013, with a coupon rate of 0.375% and a yield to maturity of 0.384%. That means Thursday’s auction will be going off at a discount, about $96.19 for $100 of value. But this TIPS also carries accrued interest (from inflation adjustments) of about 0.3%, which will also factor into the price.

I was a buyer of this TIPS back in July, and it is certainly more attractive now that the yield has risen more than 30 basis points.

Wednesday’s Fed announcement could roil the markets, so keep an eye out for reaction. If the Fed goes ahead and launches tapering, TIPS yields could rise substantially (although I theorize this has already been priced in).  If Fed decides to hold off on tapering, expect yields to decline.

More on this later. It’s good to be back.

Since May 1 of this year, we have seen a pretty-much unprecedented rise in Treasury yields, almost blindingly quick as the Federal Reserve began to slowly back away (verbally, not in action) from its bond-buying stimulus program.

• On May 1, the 10-year nominal Treasury yielded 1.66%. Today it stands at 2.82%, a rise of 116 basis points
• On May 1, a 10-year Treasury Inflation Protected-Security was yielding -0.64% and now is yielding 0.69%, an even higher rise of 133 basis points.

Can this continue? Can TIPS and Treasury yields rise another 100, 200 or even 250 basis points over the next year or two? The answer is yes, they can. I’d suggest an increase of nearly 200 basis points in the nominal 10-year Treasury looks probable if the economy continues to improve and Fed backs off from bond-buying, which holds yields down.

My thinking comes from looking at traditional Treasury rates and their spread over inflation, as shown in this chart for inflation and rates back to 1990:

So, some assumptions:

1. Inflation. As the economy improves, inflation will return to its-more-less historic rate of 2.5% a year. I am being generous here, it could be higher. The Federal Reserve is practically guaranteeing that inflation will be above 2%, not capped there, but above 2% no matter what.
2. Spread over inflation. Historically, a 10-year Treasury pays a yield about 2.5% above inflation. Obviously, that can vary widely from year to year, and has even dipped into the negative range in recent years.
3. 10-year Treasury. The current rate of U.S. inflation is 1.8%, so even if you apply a 2% spread over inflation, you get a 10-year Treasury yield of 3.8%, 100 basis points higher than it is today. If inflation rises to 2.5% and the spread rises to 2.5%, you get a 10-year Treasury yield of 5%, 218 basis points higher than today. This is entirely possible, as the numbers show.
4. 10-year TIPS. Since being introduced in 1997, the 10-year TIPS has had an average inflation breakeven rate of 2.04%. In recent years it has been riding between 2.0% and 2.5%, and is currently at 2.13%.
5. Projecting the TIPS yield. Using the average breakeven rate (which is pretty low, in my opinion), a 10-year nominal Treasury paying 3.8% results in a 10-year TIPS yield of 1.76%, a rise of 107 basis points. A Treasury paying 5% results in a 10-year TIPS yield of 2.96%, a rise of 227 basis points.

Improbable?  Sure the high end of that TIPS yield looks unlikely. But a 10-year TIPS paying 2.96% would not be an anomaly. In fact, every 9- or 10-year TIPS auction from 1997 to July 2002 had a yield higher than 2.96%:

It’s interesting to note how consistent those yields are, across a period of time that including a booming economy (late 1990s) to a savage stock market collapse (early 2000s). I would argue that these yields were the norm, not an anomaly. Instead, the ultra-low, artificially manipulated rates of 2011 to early 2013 were the anomaly, and that anomaly is now returning to the norm.

What it means. Nothing is certain. The economy could nose-dive, war could erupt in the Mideast, China could collapse. That would send TIPS yields plummeting. I am comfortable making small investments in TIPS at these current rates, to add to a portfolio.

But if the economy continues to improve, and the Federal Reserve halts bond-buying, we are looking at inflation of 2.5% a year and TIPS and Treasury rates at least 100 basis points higher.

The U.S. Treasury just announced that its reissue of a 4-year, 8-month TIPS auctioned with a yield to maturity of   -0.127%, the highest yield for any 4- or 5-year TIPS issued in more than three years. Read the announcement.

This is CUSIP 912828UX6. It carries a coupon interest rate of 0.125%, meaning that today’s buyers at auction had to ‘pay up’ to get that coupon rate, about $102.18 per $100 of value, a cost that includes about $1 of accrued inflation since April 15. This TIPS was originally issued in mid-April with a yield to maturity of -1.311% and a cost of $107.82 per $100 of value.

The auction demonstrates the incredible surge in Treasury yields since April, when Treasuries of nearly all types were trading with yields more than 100 basis points below where they stand today.

Just before the auction, this TIPS was trading in the secondary market with a yield of -0.20% or lower, so the -0.127% yield looks like a good deal for buyers, and indicates demand was probably lukewarm for this issue.

But the yield did remain barely negative, marking the 8th consecutive auction of a 4- to 5-year TIPS with a yield negative to inflation. (Holders of TIPS see their principal rise with inflation until maturity.) The last positive 5-year auction was a new issue in April 2010 with a yield of 0.550%.

Reaction to the auction. From a report by the Wall Street Journal‘s Min Zeng:

TIPS have sold off more sharply compared to regular Treasury bonds as the prospect of the Fed cutting back on easy-money stimulus reduce fears over inflation. Demand for inflation-hedging products has pulled back sharply this year …

So far this year, investors have yanked $16.5 billion out of TIPS bond funds and ETFs, already surpassing the redemption of $2.9 billion in 2006, the biggest calendar-year outflow since Lipper started tracked the data in 2002.

“It is a terrible environment as rising yields and low inflation are bad combination for TIPS,” said Jeff Tjornehoj, head of Lipper Americas Research.

Inflation breakeven rate. The 5-year nominal Treasury is currently trading at 1.70%, creating an inflation breakeven point for this TIPS of 1.827%. That means if inflation averages more than 1.8% over the next five years, this TIPS will outperform the nominal Treasury.