Treasury Inflation-Protected Securities

The downgrade of U.S. debt might have helped to send world stock markets reeling, but the target of the downgrade – U.S. Treasuries – showed impressive power Monday as a ‘safe haven’ in uncertain times.

Yields on Treasury Inflation-Protected Securities, and other Treasuries, should have risen on the downgrade – some experts predicted an increase of as much as 50 basis points. Instead, yields fell, pushing the TIP ETF up 1.21% to close at an all-time high of $115.

This one-day chart shows how Treasuries out-performed the overall bond market:

Normally, when the stock market plummets, it raises the specter of deflation, which tends to cause TIPS to under-perform overall Treasuries. That was true Monday.

But with Treasury yields so low, you might expect the overall bond market (which includes corporate bonds) to outperform with the appeal of higher interest rates. That wasn’t true Monday, because now there is a new fear: Recession, which could slam corporate profits.

Newly downgraded U.S. Treasuries are sitting at lofty levels, providing truly meager interest rates. The rate for a 10-year Treasury fell to a low of 2.33% on Monday, the lowest since January 2009. Here’s a nifty chart I found at TheAtlantic.com, which demonstrates how the S&P downgrade had a reverse effect, resulting in lower Treasury yields:

From the article by Daniel Indiviglio:

The louder S&P complains, the lower the yield on Treasuries. This is the opposite of what you might expect to see. The lower a yield, the higher the demand for a bond. Put another way, as S&P became more and more critical of U.S. Treasuries, investors were willing to pay more and more money for them.

From a Reuters report:

Treasuries benefited at the expense of risky assets including stocks, as investors maintained confidence that U.S. government debt may still be among the world’s safest assets, if no longer risk free. … “Treasuries are still a comparatively low-risk asset. I think there’s no doubt about that,” said Michael Schumacher, a strategist at UBS in Stamford, Connecticut.

This was inevitable, wasn’t it? China is the world’s largest holder of U.S. debt, and now it is holding downgraded debt.  China is not happy, as you can see in this report on Marketwatch.com:

“The U.S. government has to come to terms with the painful fact that the good old days when it could just borrow its way out of messes of its own making are finally gone,” China’s state-run Xinhua News Agency said Saturday, in Beijing’s first official response to the S&P action, according to wire service reports.

“China, the largest creditor of the world’s sole superpower, has every right now to demand the United States to address its structural debt problems and ensure the safety of China’s dollar assets,” it said.

I love the simplicity of that language: “the good old days when it could just borrow its way out of messes of its own making are finally gone.” There is so much truth to that statement that I think we should borrow 50 or so Chinese Communists to serve in the U.S. House and Senate. That is how bad things look in U.S. politics.

But China lecturing the United States on its fiscal policy – no matter how deserved – probably won’t help. Will we see a backlash response from the U.S.? Probably not, since China sits in front of a big pile of money in this poker game. In fact, the U.S. and China are economic partners, sort of an ‘arranged’ marriage.

What about TIPS? Treasury Inflation-Protected Securities, as measured by the TIP ETF, had a wild 5 days last week but ended just about where they started, and still near all-time highs:

But that price swing was relatively minor in last week’s wild market:

Next week, despite the S&P downgrade, TIPS could stay relatively stable if the stock market continues its sharp decline. If stocks rebound, as they did Friday, TIPS yields could begin rising, because the ‘safe haven’ attraction is dimmed. Even if the S&P downgrade resulted in a 50 basis point increase in TIPS yields, that would just bring the yields back to April levels.

For holders of the TIP ETF (I don’t own it), a 50 basis point increase in TIPS yield would result in about a 2% drop in NAV, hardly a disaster.

Eventually, TIPS are going to have to reflect the new reality: The economy is possibly heading toward another recession, and inflation may not be a threat in the short term.

Or … will the Fed step in with QE3 if the economy tanks (giving TIPS a boost)?

Upcoming auction. The uncertainty makes the Aug. 18 reissue of a 5-year TIPS especially unattractive, in my opinion. The likely real yield has been wavering well below  the all-time low of negative 0.55% in October 2010, right before the launch of QE2.

Friday’s yield, after TIPS took a hit, was negative 0.676% for the 5-year TIPS maturing July 15, 2016.

The auction announcement will come Aug. 11.

Bill Gross, who runs the world’s biggest bond fund at Pimco, says in an interview with Bloomberg that the U.S. economy is stalling and a recession is a real possibility.

In another Bloomberg interview, Harvard University economics professor Martin Feldstein said he thought “there’s now a 50% chance that we could slide into a new recession.”

For investors in TIPS, talk of recession is significant, because along with its many damages a recession brings the threat of deflation.

“We’re not looking at a recession yet, but we’re at a tipping point,” Gross told Bloomberg TV. “We’re at what we call a stall speed in which corporate profits don’t grow, jobs aren’t created.”

The Fed may arrange a third round of quantitative easing, known as QE3, Gross said. That would be significant for investors in Treasury Inflation-Protected Securities, because a third round of quantitative easing would inflame inflation fears.

But Gross repeats his oft-stated criticism of U.S. Treasuries, which he calls a ‘dirty shirt’ of investments, and notes there are ‘cleaner shirts out there.’

Watch the video

More pessimism … The Associated Press hit a home run with this lead-in today on its story about the worsening economy:

Shoppers won’t shop. Companies won’t hire. The government won’t spend on economic stimulus; it’s cutting instead. And the Federal Reserve is reluctant to do anything more.

Without much to invigorate growth, the economy may be in danger of slipping into a stupor like the one Japan has failed to shake off for more than a decade. And Wall Street is spooked.

While a close-to-the-brink financial and political crisis rages, the TIP ETF today hit an all-time high, reaching $113.55 in midday trading, up about 0.6% from the previous day’s close.

This is impressive, when you consider:

• The financial crisis, in theory, involves the U.S. Treasury’s ability to pay interest and principal on Treasury Inflation-Protected Securities. Obviously, buyers of TIPS do not see this as a real threat.

• The nation’s economy is slowing:

Associated Press: The economy expanded at meager 1.3 percent annual rate in the spring after scarcely growing at all in the first three months of the year, the Commerce Department said Friday. The combined growth for the first six months of the year was the weakest since the recession ended two years ago.

• In this environment, a double-dip recession seems more likely than a spike in inflation. Fear of inflation is generally considered the driving force behind demand for TIPS. But right now, investors are looking for safety first, and the fact that TIPS provide inflation protection is a nice plus.

CNN Money: Economists say the debt ceiling debate has already damaged the U.S. economy, and many worry that a deadlock could send the country hurtling into a double-dip recession.