Thu, October 28, 2010
TIPS Auction: Inflation Expectations Plus Deflation Protections
The persistence of super-low Treasury bond interest rates has led to a new oddity in the Treasury bond market. Monday's Treasury auction of Treasury Inflation-Protected Securities resulted in investors paying a price that results in a negative yield for the bonds.
Investors paid $105.50 for every $100 worth of new 4.5-year TIPS purchased. That means this batch of TIPS will pay an interest rate that is 0.55% less than the CPI. Regular Treasuries, bearing fixed interest rates, offer no protection against unexpected inflation.
The negative-yield auction shows that TIPS buyers value the protection of a guaranteed, interest-adjusted payback a great deal.. They expect inflation to resume as a result of the Federal Reserves’ second round of quantitative easing, resulting in a higher TIPS payback.
TIPS also have the property that the original principal value is paid back at maturity even if the CPI has been negative over the duration of the bond. This provides the investor with protection against deflation in the event that a Japan-style economic scenario takes hold in the US.
Although I’ve written before about this dual inflation/deflation-protection aspect of TIPS, I hadn’t thought before about the possibility of a negative-yield auction. But with yields on regular Treasuries slipping below current inflation, the bond market is now signalling that it expects inflation to tick back above 1.58% over the next five years. If inflation goes higher than that, it will just be gravy for Monday’s TIPS-buyers.