Treasury Inflation-Protected Securities

I have pretty much lost my appetite for Thursday’s auction of a new issue 10-year Treasury Inflation-Protected Security. Why? It’s hard to swallow a jawbone.

The jawboning has been coming from Federal Reserve Chairman Ben Bernanke, who last Wednesday afternoon tried to scale back fears of future Fed ‘tapering’ of its aggressive bond buying. Again today, speaking to Congress, Bernanke went dovish on quantitative easing. From the Wall Street Journal report:

Federal Reserve Chairman Ben Bernanke amplified his efforts to calm markets about the end of the Fed’s easy-money policies, pointing to a variety of economic risks that could persuade the central bank to keep its large bond-buying program going in the months ahead. …

“Because our asset purchases depend on economic and financial developments, they are by no means on a preset course,” he said. … In fact, if necessary, the Fed “would be prepared to employ all of its tools, including an increase [in] the pace of purchases for a time, to promote a return to maximum employment in a context of price stability.”

The result. Last Wednesday, by Treasury estimates, a 10-year TIPS was drawing a yield to maturity of 0.64%. Today, according to Bloomberg’s real-time estimates, that yield has fallen to 0.30%. That’s a fall of 34 basis points in 5 market days. Here is how jawboning looks in a 5-day chart for the TIP ETF (its price rises when its yield falls):

I am not a fan of buying something while the price is soaring. I haven’t ruled out participating in this 10-year TIPS auction, but my enthusiasm definitely has waned. I think I will wait until Thursday morning to decide.

I am convinced that higher interest rates (and TIPS yields) are ahead. That means the best strategy is being patient for buying opportunities.

U.S. inflation took a sharp tick upward in June, rising 0.5% on a seasonally adjusted basis, the U.S. Bureau of Labor Statistics reported today. Analysts were expecting an increase of 0.3%.

This is ‘headline’ inflation, technically called the Consumer Price Index for All Urban Consumers (CPI-U). It has risen 1.8% over the last 12 months, indicating that overall inflation remains mild.

For holders of TIPS and I Bonds, the important monthly number is the non-seasonally adjusted rise in inflation, which was 0.2% in June and 1.8% over the last 12 months. This number is used to determine increases in TIPS principal and future interest rates of I Bonds.

Energy costs were the driving force behind June’s increase in inflation.

• The cost of gasoline rose 5.7%
• The cost of fuel oil rose 6.3%
• Overall energy rose 3.4%

Apparel was up a sharp 0.9% in June and medical care services was up 0.4%, breaking a string over very low monthly increases.

Core inflation. The Federal Reserve tends to watch core inflation, which it says it wants to contain under an annual rate of 2% and a danger level of 2.5%. Core inflation increased 0.2% in June, but only 1.6% over the last 12 months, well under the Fed’s goal.

For TIPS buyers? Higher inflation increases the attractiveness of TIPS as a shelter, but it also raises the fear of tightening by the Federal Reserve. TIPS have been in a bit of a rally since last Thursday, and that looks likely to continue today. Tomorrow, Federal Reserve Chairman Ben Bernanke will be speaking before Congress, and we can expect another news jolt leading up to Thursday’s auction of a 10-year TIPS.

Right now, it’s hard to see the long-term trend in headline inflation, which seems to jump in some months and plummet in others, usually along with energy prices.

Federal Reserve Chairman Ben Bernanke might have been feeling a little guilty about being so honest about the Fed’s  future ‘tapering’ of purchases of Treasury bonds. Bernanke’s heads-up (once in May and again in June) resulted in a dramatic increase in Treasury yields, pushing the yield on a 10-year TIPS from -0.65% on May 1 to a peak of 0.66% on July 5, a 131 basis point swing.

So last Wednesday, Bernanke tried to slam the lid on this Pandora’s Box, hoping to also put a lid on rising interest rates. From the Christian Science Monitor report:

Speaking at a National Bureau of Economic Research conference in Cambridge, Mass., Bernanke seemed to allay investors’ concerns about early tapering. Unemployment is too high and inflation is too low to do away with easy-money policies just yet, he said. …

Overall, Bernanke said the Fed’s outlook of the economy is a mixed bag — “somewhat optimistic,” but warily eyeing “significant risks.”

It worked. The yield on a nominal 10-year Treasury dropped from 2.7% on Wednesday to 2.61% on Friday, down 9 basis points. The yield on a 10-year TIPS dropped from 0.64% on Wednesday to 0.55% on Friday, also down 9 basis points. This chart of the TIP ETF shows that Bernanke’s words late Wednesday had an immediate effect on the market, stopping a months-long slide in TIPS prices:

And now … The immediate effect might be to somewhat dim the attractiveness of Thursday’s 10-year TIPS auction. At mid-week, it looked like buyers could get a 0.625% coupon rate, now a 0.5% coupon rate looks likely.

This will be an interesting week, because in fact I think we all know tapering is coming, possibly this year. Bernanke’s boost to bonds could already be over.

The U.S. Treasury will announce tomorrow that it will be auctioning a new-issue 10-year Treasury Inflation-Protected Security on July 18. This will be CUSIP 912828VM9. The coupon rate and yield to maturity will be set at auction.

Update: Here is the Treasury’s auction announcement.

Yield = positive, a rare thing. Right now, it looks like this 10-year TIPS will auction with a yield to maturity of 0.59% (but a lot can change in a week). This will be the first positive yield for a 10-year TIPS since November 2011 and the highest yield in two years. Here’s a chart showing the steep decline in yields after mid-2011; and how the trend began reserving after March 2013:

Here is another chart that shows just how quickly TIPS yields have risen from their ultra-low levels of the last two years:

This chart also shows there’s plenty of room for TIPS yields to continue rising to reach more ‘normal’ levels, say about 1.5% on a 10-year TIPS. My prediction is that 10-year TIPS yields will climb (or fall) at about the pace of a 10-year nominal Treasury.  The bond market is pricing in future ‘tapering’ of bond-buying by the Federal Reserve. The Fed hasn’t started tapering and we don’t know if it will, or when.

If the economy slumps, the Fed won’t taper and the bond-buying will continue, and TIPS yields will head back to zero or below. If the economy improves, yields are going to rise.

Inflation breakeven rate. The 10-year nominal Treasury closed Tuesday at 2.65% and the 10-year TIPS was yielding 0.59%, creating an inflation breakeven rate of 2.06%. This means if inflation averages more than 2.06% in the next 10 years, the TIPS will be a better investment than a 10-year Treasury. Although the breakeven rate has risen from the 1.95% range a few days ago, this is still an attractive rate. (I usually say that TIPS are ‘cheap’  when the breakeven rate hits 2%, and this is very close.)

Here is a chart showing the breakeven rate over the last 10 years; while the rate can fluctuate wildly at times of deflation, it usually remains above 2%:

TIPS vs. I Bonds. Ten-year TIPS traditionally have paid a 1% yield premium to I Bonds, because of the tax advantages and flexibility of US Savings I Bonds. TIPS  still haven’t reached that level, mainly because I Bonds cannot earn a negative yield. So I think I Bonds are still a better investment in mid-2013. That means: First, buy I Bonds up to the limit ($10,000 per person per year), then buy TIPS.

Strategy? I probably will be a buyer at the July 18 auction, because I have a 10-year TIPS maturing this month. This will be buy-and-hold-to-maturity investment, so even if yields rise in the future, the investment is ultra-low risk. This will be a rollover, not a bet-the-house investment.

I suspect the trend has turned on TIPS and we will see gradually increasing yields. If you want to gamble on that, this TIPS will be reissued in September (when the Fed in theory could begin tapering). You could sit on the sidelines and see what happens.

Soon after I woke up Friday morning, I heard on the radio that the U.S. economy had created 195,000 jobs in June and many more in April and May than was previously thought. My immediate thought was: “Ooops, that won’t be good for TIPS.”

Here is the reason, summed up nicely in the Associated Press jobs report:

The job growth suggests a stronger economy and makes it more likely the Federal Reserve will slow its bond purchases as early as September.

And here is what a 5-day, holiday-week chart looked like for the TIP ETF, which holds a wide range of Treasury Inflation-Protected Securities, and SPY, the ETF that tracks the Standard & Poors 500:

The stock market greeted Friday’s positive jobs report with a buying surge, but the overall bond market – and especially Treasuries – suffered.

In more-normal times, TIPS investors are OK with positive economic news, because it brings the possibility of higher inflation, which is the reason investors buy TIPS. And in the reverse, negative economic news brings the fear of deflation, which is not good for TIPS.

At the moment, we are in non-normal times, and the situation is reversed. TIPS will be helped by negative economic news and hurt by positive economic news. This is because of the overhanging fear of Federal Reserve ‘tapering’ (or outright halting) of bond purchases. Any positive economic news is going to be negative for TIPS.

TIPS in mid-2013 face the worst-possible conditions: Rising interest rates combined with very low inflation. As long as overall interest rates are rising, and annual U.S. inflation remains below 2.0%, TIPS will have little appeal to investors.

The result will be higher yields and lower prices for TIPS on the secondary market.

Positive economic news will mean higher interest rates. This is almost guaranteed by the Fed, and the market has started pricing this in.

Inflation is the X Factor. TIPS will suffer until we see some evidence of igniting  inflation. Until then, TIPS will be getting more and more attractive as a buy-and-hold-to-maturity investment.

In other words: Buying opportunity.