Fixed Income Recap

Treasurys were little changed today on mixed equity markets and Fed buying that went as expected. The two-year finished up 1/64 on the day, and the ten-year was lower by 2/32. The benchmark curve steepened by 2 basis points, and currently sits at +228.5 bps. A basis point represents .01%.

Fed purchased $6 billion in Treasuries maturing from 5/31/12 to 8/15/13. Cumulative purchases stand at $101.7 billion.

Inflation Expectations
Treasury Inflation Protected Securities (TIPS for short) are used by investors to hedge against the risk of inflation. They are backed by the full faith and credit of the US Government, just like regular (nominal) Treasurys, but instead TIPS pay a fixed real rate of interest on principal that is adjusted for inflation as defined by the Consumer Price Index (CPI). So when inflation increases so does the investor’s nominal return.
TIPS also play an important role in Inflation expectations. As investors become more concerned about inflation, the gap between the yields on TIPS and nominal Treasurys widens out. This gap is called the “Breakeven Rate”. The graph below shows the ten-year breakeven for the past 12 months.

The rate is forward looking, meaning that the 10-year breakeven is an estimate for average inflation over the next 10-years.

Notice that on 11/20/08 the 10-year breakeven actually went negative. Oil had dropped from $145 to below $50 a barrel, the credit markets had seized up following Lehman’s bankruptcy which halted production activity and the Fed had yet to begin its long-term securities purchases. As evidenced by the graph, deflationary concerns that were unreasonable even given the circumstances, have since been squashed.

I think TIPS remain a good buy. The quantitative easing efforts by the Fed have begun to work, but if we continue to be truly forward looking we can’t ignore the red flags. Congress would rather solve the problem by re-inflating the housing bubble instead of allowing the market to correct itself to a healthy sustainable level, and they appear to have the Fed’s services at their disposal in order to do so. Fed/Politician interconnectedness spells danger when it comes time to removing liquidity from the system and the result will likely be inflation.

I could definitely be wrong. If the Fed can return to a state of independence, and pull the extra liquidity from the market at the appropriate time, then above average inflation could not happen. I’m certainly not wishing for any monetary policy failure, but judging by what breakevens have done so far this year, I’m not the only one with these concerns.

Have a great evening.

Cliff J. Reynolds Jr., Junior Analyst