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The TIPS auction that took place yesterday continued to place inflation-protected yields in negative territory. The yield on the issue was -0.089 percent and the ten-year yield closed to yield -0.111 percent.

The negative yield on these inflation-protected securities does not mean that investors will not make any money on their holdings because the principal of these securities will increase if inflation rises.

The yields of the TIPS are negative because the yields on the US Treasury yield curve are so low. And the yields along the yield curve are so low because of the amount of money that has flowed into this market through a “flight to quality” arising from the debt problems faced by Greece and other eurozone countries.

The 10-year US Treasury bond closed to yield 2.28 percent yesterday. If one takes the difference between this bond yield and the yield on the 10-year TIPS issue as an estimate of inflationary expectations, then one can state that investors are expecting that inflation will average about 2.4 percent over the next ten years in the United States.

That is, if 10-year bonds are yielding around 2.30 percent in the market and the inflationary expectations of investors are approximately 2.40 percent, then the TIPS yield must be around -0.10 percent to fully incorporate the possible effect of inflation on the real value of the bonds.

In the latter part of January 2012, when the last auction of TIPS came to market, 10-year US Treasury bond yield was around 2.00 percent and the yield on the 10-year TIPS issue was around -0.15. The relationship between the two yields implied that investors expected inflation to average around 2.15 percent over the next ten years.

At the end of December 2011, inflationary expectations were around 2.00 percent, calculated in the same way.

The most important conclusion that can be drawn from this is that, in the financial markets, investors are now building more inflationary expectations into their future projections than they were several months ago.

The actual rate of consumer price inflation, year-over-year, was 2.9 percent. (Note that this rate of increase is down from a near-term peak of 3.9 percent in September 2011.)

Inflationary expectations, as reflected in the bond markets, tend to lag behind actual inflation.

The auction yesterday reflected strong investor interest as Wall Street dealers, who underwrite the Treasury auctions, were left with only 39 percent of the offering, which was down from the 50 percent they received in January’s auction. Also, this was the second lowest share of the 10-year TIPS auction for dealers since the market began in 1997.

If one is looking for some evidence of when the bear market for US Treasury securities might begin, then this, I believe, is a good place to start.

As I have argued earlier, the yield on the 10-year US Treasury security is currently as low as it is because the United States Treasury market still has a lot of funds that are there for 'safety' reasons. My belief is that this yield should be above 3.00 percent if the flight to quality money was not in the market.

Thus the yields on US Treasury securities, in my mind, need to rise just in order to get back to a range that is more consistent with where the United States is in the economic cycle.

But the next concern of the investors seems to be about a coming bear market in bonds. This bear market is to come once the economy begins to grow faster ... more than the 2.0 percent to 2.5 percent rate of growth now being experienced ... and when all the money the Federal Reserve has pumped into the banking system starts to really impact prices in the economy.

My suggestion is to watch the spread between the yield between the 10-year Treasury bond and the yield on the 10-years TIPS issue. As real economic growth begins to pick up, the TIPS yield will have to increase to reflect the growth of the real economy. This yield will not be determined the way it has been determined in the recent past.

And, if the real yield on the TIPS issues rise, the yield on the 10-year Treasury bond must rise as the investor’s inflationary expectations get added onto the yield they are getting on the TIPS. If the real yield on the TIPS issues rise to, say, 1.50 percent and investors expect inflation to be in the 2.5 percent range, the 10-year bond should yield at least 4.00 percent.

As expectations of the real rate of return rise and inflationary expectations rise, the yield on 10-year bonds should be off to the races. Then one can say that the bear market has arrived.

Source: TIPS Auction Still Negative