Treasury Inflation-Protected Securities

So Standard & Poors issues a negative outlook on U.S. Treasuries this morning, and the stock market falls into turmoil. The Dow average ended up rallying to close at -1.14% for the day. (In reality, that is a non-event, isn’t it?)

But you would expect some shakeup in Treasury issues. A negative outlook should mean the risk premium rises, and that means higher interest rates.

Wrong.

Here is the chart of the iShares Barclays TIPS ETF for today:

One-day chart for TIP ETF

The news wasn’t greeted well in the morning, but by the end of the day this ETF managed to squeak out a 0.3% gain. Impressive.

For the record, I am not high on this TIP ETF at these levels. Here is the five-year chart, and my advice is … don’t get excited when your investment hits a five-year high, especially an investment that is completely controlled by monetary policy:

5-year chart fot TIP ETF

The bigger immediate issue is the 5-year Treasury Inflation-Protected Security that will be auctioned Thursday. It is likely to go off at a negative base interest rate, something in the range of -0.25% best case to -0.7% worst case. (But the principal will rise with the inflation rate over the next five years.)

Here are the rates I am finding today on Barrons.com:

First of all, note that all these issues were positive today. The closest to a 5-year TIPS issued this week is the July 15 2016 issue, which has a base yield of -0.306%. But the issue one year earlier is yielding -0.693%.

It is all going to come down to demand on this week’s auction. If there is heavy demand — and I wonder about that with today’s positive move — then how negative will the yield go?

Conclusion: Still looks iffy on this issue. A negative base yield doesn’t appeal to me. However, if the cash is in a money market account, the inflation-adjusted rate of 2.5% to 3.0% does look a little more attractive.

My mind has been wandering to municipal bonds — but safety is more of an issue there.

If you have thoughts, please post them. I’d love to start a discussion about this week’s 5-year TIPS issue.

These are words that investors in Treasury securities don’t like to read:

Standard & Poor’s cut its ratings outlook on the U.S. to negative from stable while keeping its triple-A rating on the world’s largest economy. Relative to its AAA-rated peers, the U.S. has very large budget deficits and rising government indebtedness, and the path to addressing those issues is unclear, S&P analysts said.

Yes, the U.S. keeps its AAA rating, but the massively high deficits are worrying the world, even as the rest of the world is acting to slow down inflation by inching up interest rates. (U.S. fiscal policy has also been rewarding borrowing and risk, while slamming savers with near-zero interest rates.)

We believe there is a material risk that U.S. policymakers might not reach an agreement on how to address medium- and long-term budgetary challenges by 2013; if an agreement is not reached and meaningful implementation is not begun by then, this would in our view render the U.S. fiscal profile meaningfully weaker than that of peer ‘AAA’ sovereigns.

The stock market is not liking this — the Dow average is down nearly 2% this morning.

This needs to serve as a wake-up call to Washington.

The Treasury’s response

A senior Treasury department official – assistant secretary Mary Miller – had this response to the S&P action:  “We believe S&P’s negative outlook underestimates the ability of America’s leaders to come together to address the difficult fiscal challenges facing the nation.”

Another interesting video from FT.com on inflation:

George Goncalves, head of US interest rates strategy at Nomura Securities, tells the FT’s Michael Mackenzie that he does not expect to see substantial inflation in the near future. Mr Goncalves says higher commodity prices are a tax on society but not inflationary.

Watch the video

Point to ponder: If you agree with Goncalves that inflation is being overestimated, this week’s 5-year TIPS, which will probably go at a negative base interest rate, is pretty unattractive. It’s still a no-risk investment when held to maturity, but better opportunities might arise within a year.

From FT.com, a fairly optimistic viewpoint from Henry Kaufman.

Henry Kaufman, the legendary Wall Street economist known as “Dr Doom” for his pessimistic forecasts on inflation and interest rates in the 1970s and 1980s, says he does not like his nickname but understands that it reflects people’s unwillingness to hear a negative view or bad news. He says the US is not in the inflationary period of the 1970s.

Watch the video