More Small Things

by: Jeffrey Snider

On April 23, 2015, the US Treasury auctioned off $18 billion in inflation-indexed bonds maturing in April 2020. These 5-year TIPS stopped out at the lowest yield for that particular security class in almost a year before then. Coming as it did during the spring of 2015, it was met with the usual textbook applied commentary, where bond investors were supposedly pricing Janet Yellen’s “transitory” scenario. The oil and commodity crash of late 2014 was by convention nothing more than an aberration, and the auction results appeared to confirm as much.

The sharp bidding for inflation protection, particularly without a similar move in the 5-year UST security (not TIPS), meant that inflation breakevens, a measure of market inflation expectations, jumped 10 bps after the auction. At 170 bps, the 5-year breakeven was about 65 bps off the low and at that moment more than half retracing the considerable pessimism that had been provoked by during the (initial) oil crash. Positivity was dominant again.

The market likes TIPS,” said Edward Acton, a U.S. government-bond strategist in Stamford, Connecticut, for Royal Bank of Scotland’s RBS Securities unit, one of 22 primary dealers obligated to bid at U.S. auctions. “This disinflationary pressure has eased off, and we’re just waiting to see how strong and how quickly inflation pressures can surprise to the upside.”

That, of course, never happened. Inflation instead sunk much lower as did the global economy. Was it merely confirmation bias that “everyone” simply saw what they wanted? The thing about auctions is that pricing is never strictly about fundamentals, in the case of TIPS meaning inflation expectations. Demand for TIPS (or any) OTR paper may be robust for reasons that have nothing to do with inflation or credit.

Almost exactly one year before, on April 17, 2014, the Treasury had auctioned, as it typically does, the previous year’s 5-year TIPS. The demand for that security (912828C99) was even further off the charts. The yield on the day before, admittedly in late stage OFR status, was -6 bps. The market was anticipating heavy demand, but the settled yield after the auction was -21.3 bps. That drop in TIPS yield coupled with a selloff in the 5-year UST left inflation breakevens for the 5-year maturity spiking higher by more than 22 bps in a single day.

The commentary produced that day was almost exactly the same as it would be one year after.

The stats were off the charts,” said Stanley Sun, a New York-based strategist at Nomura Holdings Inc., a primary dealer, said in a telephone interview…

“Break-evens had been very depressed ever since the March FOMC meeting,” Sun said. “Given how beat up they were, with consumer price index surprising to the upside this week, and after the strong auction investors are starting to catch up to the fundamentals.”

And once again, convention got it all wrong. Fundamentals were weakening and it was the bond market that showed as much (long, long before economists would realize it). What was going on in TIPS? I wrote a week after that particular auction coming from the opposite perspective:

That is what makes the move in 5-year TIPS so very eccentric; the typical move in inflation breakevens coincident to such tightening bias is in the opposite direction. Normally I wouldn’t even comment on such a brief change over only several days as this all may turn out to be absolutely nothing, but since the 5-year is the most active place right now, and TIPS aren’t the most vibrant and noteworthy pieces of credit, it seems worth watching.

What was truly unusual about that auction was who it was that did all the buying. The largest proportion was awarded to Indirect Bidders, a class of auction participants noteworthy for including foreign central banks (and other private banks acting on their behalf), far more than at any other auction for 5-year TIPS (to that point). They took nearly 60% of the allotment, compared to an average of 40% over the prior 10 years.

There was, however, no spill-over into other areas of inflation trading and expectations. The 10-year TIPS and 10-year breakevens moved a little on April 17, 2014, but remained steadfast in the sideways action that had developed going all the way back to July 2013. That was an important clue, for a rise in the 5-year breakeven without one in the 10-year meant, fundamentally, the market was actually pricing increasing risk.

As noted last week, it would take Janet Yellen two more years plus all the negative economic and financial events contained within them to finally figure out the chief risk in all of this. Inflation securities like TIPS are not strictly priced based on considerations of the CPI, even though they are indexed to it in the long run. All USTs are subject to liquidity considerations of one kind or another, including hyper demand from foreign official sectors that tells us something, maybe even just a small something, about “dollar” conditions globally.

The 5-year TIPS auction in April 2016, last year, was notable in this study for not being notable. There was no discernable disturbance, as the yield moved 4 bps lower for that auction. The effect on breakevens was a total of 7 bps given that the 5-year UST sold off slightly, raising its yield by 3 bps.

The latest auction this year has been far more like the prior two (2014, 2015) than the last one (April 2016). As in April 2014, the bid on April 20, 2017, was enormous. The 5s TIPS yield dropped by more than 12 bps, and since the equivalent 5s UST sold off for 4 bps more, the breakeven rate rose by a total of 16 bps just that one day. But because the 10-year breakeven was constant, the 5-year/5-year forward rate plummeted to 188 bps, the lowest since the election.

I’ll spare you reprinting the positive inflation and fundamental commentary from last week; you can just read what was already quoted above and apply it to any one of these three auction results. Instead, we should recognize that indirect bidders last week were awarded $11.81 billion of the $15.92 billion in competitive bids allotted, or 74% of the auction. Primary dealers took down less than 17%, a low for them.

The funny thing is, despite it being unrelated to US fundamentals this is how liquidity risk is supposed to work, or at least show up. A deficiency creates an irregularity that stands out because the rest of the market refuses to adjust to it on that basis. Like ripples on a pond, it radiates outward further affecting other prices and indications (like 5-year/5-year forward inflation rates). The result is at least a cascade of contradictions that should at least require pause before cheaply assigning it to convention.

Of the last four 5-year TIPS auctions, only the one last year was, as stated above, free from disturbance. This may seem to be a random relationship to the mainstream, but what was different in terms of liquidity about April 2016 as compared to April 2014 and April 2015? What might that tell us about at least a possible turn in systemic capacity in April 2017?