Thursday’s 5-year US Treasury TIPS auction was something of a noteworthy one, according to Kit Juckes at Societe Generale. Click to enlarge…
As the results page shows the auction ‘stopped’ at a yield of -1.311 per cent.
But what’s more interesting according to Juckes is the following (our emphasis)
In the language of bond auctions, it had a low bid/cover ratio, a long tail and was a bit of a mess! A 3 year history of 5yr real yields (TIPS), next to conventional 5yr Treasury yields and the difference between the two (break-even inflation) provides some context: In October 2008, 5yr real yields reached 3.2% and on April Fools’ Day 2013, they reached -1.77%. We have seen a very sharp correction of a small part of that long fall in the last two weeks. 5yr conventional Treasury yields have also fallen since 2008, of course. But since the start of this month, conventional yields have actually fallen a little further, as soft US data is interpreted as either a temporary soft patch for the economy or the end of a temporary period of strength. We, of course are firmly in the former camp. The result though, is that the rise in real yields is matched by an equally sharp fall in breakeven inflation rates. 5yr breakeven inflation rose for a distorted low of -0.5% in October 2008, to almost 3% in 2011, but in this month alone we have seen a fall of 0.6% to 1.95%.
Whether this is a position-driven adjustment or capitulation by those who fear that current monetary policies must inevitably lead to an outbreak of inflation, it looks very like a series of dominoes falling over.
So what we’ve seen is a perfect storm for TIPs, which obviously look much less appealing when the prospect of deflation raises its ugly head.
The key point really, however, is that with conventional yields unable to go anywhere but sideways — because of the zero lower bound — falling inflation expectations have no way to express themselves other than in TIPs.
As Juckes notes, what’s really meaningful however is the idea that we may have been reading the signals from the TIPs market incorrectly for a while. So it wasn’t necessarily a fall in real yields which we were observing until now — i.e. that the TIPs market was indicating less of a return from a conventional bond in real terms because inflation expectations were high — but rather that the inflation you needed to break-even on a TIPs investment had somehow gone up instead.
Looking at it in terms of commodity prices you suddenly get the picture regarding what’s been going on:
As can be seen, the inverse relationship between real yields and commodities was well correlated until the latter part of last year, meaning the more commodities went up in price, the lower the real yield on a conventional bond got (as implied by the TIPs market), meaning a TIPs security could command a greater premium.
But then somehow the relationship broke apart. Commodities started to fall in price — which would ordinarily suggest the premium for a TIPs security should fall as well. But for some reason TIPs kept trading at much too big a premium, relative to what commodities were telling us.
It is as if the TIPs security was fetching a premium for an entirely different reason for most of that year — we’d argue possibly because it was expressing its dual protective quality as both an instrument that protects in inflation and during deflation. And also because of the fact that conventional yields could not fall much lower without generating nominal negative yields, while some TIP securities had already benefited from inflationary compensation on their principal sums, providing them with something of a buffer in a longer-term deflationary environment.
That is to say, you are prepared to over pay for a TIPs security relative to a conventional one because you can draw a slightly higher yield — which is derived from an augmented principal — in real-terms.
Think of it this way. If I bought a TIPs security for $10,000 two years ago, and it was set to pay out an adjusted 3 per cent, it could in the event of 2 per cent CPI rate over that time be paying out as much as $306 rather than $300, and be worth $10,200. If I fear deflation will strike any minute, I will want to be compensated for that yet to be paid out coupon that captured the rising CPI, which in of itself is now worth more in real terms than the coupon on a conventional.
Of course in a new auction there is no cumulative CPI adjustment to be skimmed, making the bond much less appealing in a declining CPI environment.
The conclusion being, the reason TIPs outperformed both conventional Treasuries and gold from the latter half of last year was possibly because CPI was still printing positively despite the hiatus in commodity prices.
That is to say, it was possibly the last opportunity to benefit from a positive CPI print in TIPs, at least when compared to the returns derived from conventional bonds or other zero yielding securities. That incentive has, however, now begun to disappear.
If the disinflationary/deflationary trend continues, meanwhile, it’s likely TIPs will trade ever more closely with conventionals.
If and when the two do converge, that will leave conventional yields at greater risk of turning negative (with the only caveat to that the eventuality the government responds with heaps of new supply instead). In that scenario gold may once again begin to look appealing. Though, so would banknotes stored in mattresses and vaults — and any other bearer securities whose store of value can be guaranteed by the government.
Related links:
Capping the gold price - FT Alphaville
Risk premium or deflation charge? – FT Alphaville
Treasuries, TIPS, and Gold (Wonkish) - Paul Krugman’s blog