Treasury TIPS Break Out: Is This The Move?

by: John M. Mason

The yield on the 10-year U.S. Treasury inflation adjusted bond closed above a positive 10 basis points today. Actually, it closed at a positive 13 basis points.

The yield on the TIPS bond has been below zero since the fall of 2011. My reasoning for this is that investment money escaping the financial crisis going on in European sovereign debt sought out a safe haven and the funds flowed German and United States debt.

The yield reached a low of a negative 90 basis points in December of 2012. For most of April 2013, the yield on TIPS was in the negative 70s.

The movement toward positive territory took place in May and the break through zero came at the end of last week on June 7. These movements can be seen in the accompanying chart.

I wrote about this movement last week. I interpreted this as a movement of money that had previously flowed to the United States in fear of the financial difficulties being experienced in Europe as a reverse flow of funds back into Europe as international investors gained sufficient confidence in the safety of the sovereign debt on the continent.

To me, the low or negative yields on longer-term U.S. government debt was not a result of the actions of the Federal Reserve, but was a consequence of where international investors were placing their money.

I don't believe that even the Federal Reserve can produce the results we have seen in the U.S. Treasury market over the past couple of years.

My forecast on Treasury yields was based on what happened to the yields on TIPS bonds. I argued that if the European money left the Treasury market that the yield on TIPS would head toward a zero yield and then break through on the positive side.

My question was how far the yield would rise above zero and how fast might this be attained. I must admit the breakthrough has come sooner than I expected.

But the European sovereign debt crisis has not completed its course. There could be some periods of time in front of us when money comes rushing back to the U.S. Treasury market because of the problems that still exist in Europe. There are still lots of things that have to change before the European financial crisis can be put to bed.

Still, the yield on TIPS securities is above zero.

The important thing about this is the impact the above mentioned movement in international money flows has had on the 10-year U.S. Treasury bond. The movement in the 10-year U.S. Treasury TIPS has been matched by an almost parallel movement in the10-year U.S. Treasury bond. The spread over the past month between the two yields has been between about 210 basis points to around 240 basis points. The spread was higher at the start of May than it is now.

The reason for this parallel movement is that, as many have argued, the difference between the yield on the TIPS bonds and the yield on the "straight" bonds is the market's expectation of inflation. If changes in inflationary expectations don't change, then there should not be much movement in the spread between these two yields.

As far as I can tell, there has been no change in inflationary expectations over the past six weeks. Thus, the parallel shift in the two yields was to be expected.

If the yield on the 10-year TIPS bond returns to more normal levels as the flow between European and American financial markets settles, then we should see 10-year TIPS trading in the range of a positive 75 to 100 basis points.

When this movement takes place I would expect the yield on the "straight" 10-year U.S. Treasury bond to return to a level a little above 3.00 percent. This bond closed today yielding around 2.25 percent.

I firmly believe that if the international money continues to flow from American financial markets to European financial markets that the Federal Reserve will be unable to stop this rise in the 10-year Treasury yield.

Long-term interest rates have been distorted to extremely low levels, not because of the Federal Reserve, but because of the risk-averse behavior of international bond investors. I believe that as this money reverses its flow, the long-term interest rates will rise regardless of what the Fed tries to do.

This movement does not mean, however, that money market rates will rise. The Federal Reserve will still be able to exert its will in these short-term markets.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.