The Treasury Bond Market: The TIPS Mystery

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 |  About: iShares TIPS Bond ETF (TIP)
by: John M. Mason

The Treasury Department is concerned about the market for its inflation-protected securities. As a consequence, the Treasury has gone to the bankers to see what problems might exist in the market.

Apparently, the big concern has been the bond-market sell-off that has taken place over the past couple of months. Jacob Lew and the Treasury Department want to know what is going on!

The rise in the yield on TIPS over the past two months or so has been fairly steep. The rise at one time was about 140 basis points from April 5, 2013 to June 25, 2013. The move came from about a negative 80 basis points at the earlier day to about a positive 60 basis points at the latter date.

According to Min Zeng and Carolyn Cui in the Wall Street Journal, "Many analysts tie the rise this year in inflation-adjusted interest rates to a pickup in the U.S. economy."

The argument here is that the interest rate on TIPS is related to the real interest rate, which is associated with the rate of growth of the economy. Therefore, if the real economy is starting to grow at a faster pace, the real rate of interest should rise… hence, the yield on TIPS should rise.

But the real economy has been rising for some time at around 2.0 percent, give or take a little.

This should mean that the real rate of interest, the yield on TIPS, should be more in the neighborhood of 200 basis points rather than just 60 basis points or whatever.

The real question in this picture is why the yield on TIPS was ever negative!

I refer back to an article written by Jeremy Siegel and Jeremy Schwartz in the Wall Street Journal that appeared on August 22, 2011. They write:

"One market that now makes no sense to us is the popular Treasury Inflation Protected Securities (OTC:TIPS), where recent yields should be enshrined in Ripley's "Believe It or Not!" The yield on the benchmark 10-year TIPS turned negative for the first time in history, meaning investors are now lending money to the government with the hope of receiving a sum 10 years from now that is worth less in purchasing power than the dollars they fork over today.

This astounding situation can only be justified by extraordinary pessimism about the prospects for the U.S. economy. Economic theory predicts that the real yield on long-term TIPS should approximate the real growth in the economy. And when these securities were first floated in 1997, investors received a 3.4% yield, which was very close to the 3.6% average GDP growth over the previous 50 years. The average yield on the 10-year TIPS since it was floated has been 2.5%."

And Siegel and Schwartz conclude, "We believe that when investors awake from their depressed state, they will realize that they don't have to lend the U.S. government money for 10 years at a negative real yield."

Returning to the Zeng/Cui article, the authors argue that:

"government officials are concerned that the rise in real rates also signals that the TIPS market may be hamstrung by a lack of buyers and sellers in the market, traders and analysts said.

The Treasury frequently has asked big banks for input on steps to make the market work better, but the question about what has driven this year's action is unusually direct and reflects anxiety about how a once-hot market crowded with individual investors might handle further volatility, observers said."

The major concern is whether or not the Treasury has oversupplied the market with TIPS and that this is accounting for the current rise in the yield on these securities.

There is also concern that the market is less worried about inflation at this point in time and, consequently, there is less demand for securities that provide inflation protection.

Neither of these possibilities resonates with me.

I have written quite a few posts on this issue beginning on May 29 and following on through much of June. The conclusion I have reached for the behavior of the yield on TIPS is connected with the financial problems in Europe. The yield on TIPS dropped significantly during a time when there was a flow of money out of European financial markets, money seeking less risky investments. US Treasury securities were a haven for these risk-averse investors.

The yield on TIPs turned negative during the period of these flows and remained negative until the flows reversed themselves and returned to Europe.

The movement of the yield on TIPS from around a negative 70-to-80 basis points came at exactly the time that the yield on longer-term German bunds (another haven for risk-averse funds) began to rise dramatically. International investors were getting out of the least risky bonds, German bunds and US Treasury securities, and putting their money into riskier European debt. It was at this time that the spreads between the yields on the German bunds and on the yields of other European sovereign debt, that of Spain, Portugal, Greece, and Italy, narrowed significantly.

This movement continued as the yield on TIPS rose into the positive 40-to-60 basis point range.

The recent sale of Treasury inflation-protected bonds has been a strong one, putting to rest, at least for the time being, the Treasury Department's concern that the market is oversupplied:

"The $15bn 10-year TIPS were sold at a yield of 0.385 per cent, after being quoted at 0.41 per cent just before the sale, an indication of strong buying from clients via primary dealers, who underwrite auctions for the Treasury."

Note: this was the first time that an auction for the 10-year TIPS was positive since November 2011.

On Friday, the 10-year TIPS closed to yield 0.264 percent.

The TIPS market seems to be doing just fine. Of course, it will be interesting to see what happens to the yields in this market over the next couple of months.

The US Treasury market, as a whole, seems to have stabilized somewhat after all the "tapering" talk that has been going on concerning the purchase of securities by the Federal Reserve. Mr. Bernanke's testimony in front of Congress this week seemed to make financial market participants a little more optimistic about the continuation of the Fed's $85 billion purchase of securities every month. But this doesn't change anything for me about the fact that the yield on TIPS is positive. As I have written above, the return to positive territory, to me, was a result of money flowing back into Europe. As long as the money stays there, the yield on TIPS will remain positive.

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.