Thursday, September 23, 2010

Nominal Treasuries and TIPS: A Diverging Inflation Outlook?

As of next week, I will be returning to the financial industry, while maintaining some of my teaching responsibilities at Stern. Every effort will be made to maintain a pace of approximately two new postings each week, although, on rare occasions, that standard may not be fully met.- AK

One of the most intriguing market reactions to the FOMC's signal last week that additional purchases of Treasuries may be in store is the strong rally in TIPS, which has fully kept up with that in nominal long-term Treasuries. This has helped sustain the strength that TIPS have demonstrated since the beginning of the month, and which has led to a rebound of the break-evens in the 10-year sector by about 30 basis points.

That nominal Treasuries have rallied in the aftermath of the Fed's announcement is hardly surprising, although we felt that it contained a bit of a "jumping the gun" element ( Still, the enhanced prospect of potentially sizable purchases that would likely remain concentrated in the long end of the market, can explain the resumption of the rally that had suffered a modest setback earlier in the month.

The impressive vigor of the rally in the TIPS market (which would almost certainly be excluded from any Fed asset purchase program) can only be attributed to the part in the FOMC statement that expresses the policymakers' discomfort with the rate of core inflation running below the Fed's medium-term objective, of presumably closer to 2%. Another way of putting it is that TIPS became suddenly more attractive because the Fed signaled that they may provide more liquidity to the system via quantitative easing to fend off any deflation risk- and possibly reflate the economy.

Something though does not quite sit right with the above interpretation of the strength of the TIPS market. If TIPS are rallying because the Fed's anticipated second round of quantitative easing will cause more inflation (therefore making TIPS appealing), why don't nominal Treasuries see that perceived threat of higher inflation, and have, instead, rallied as well by a roughly comparative amount?

The only plausible explanation here is that Treasuries have evidently made the assessment that the extra demand for long-term securities by the Fed will squarely outweigh the setback that such maturities would otherwise be suffering as a result of any heightened inflation fears. This is, in our opinion, a somewhat heroic proposition, as patterns of market behavior over the medium-term have almost invariably shown that concerns about inflation tend to be a more reliable and potent driver of nominal long-term yields than supply-related considerations.

The above analysis does not imply that the widening of the TIPS break-evens since the beginning of September will be reversed. In fact, that push may continue, albeit in a somewhat choppy manner. However, such a move would more likely be fueled by a slow retreat of the most intense deflation concerns that would allow TIPS to maintain a firm underlying bid consistent with the tacit view of 1.75-2.0% inflation over the long-term. At the same time, Treasuries may remain close to a standstill, pulled in opposite directions by that same inflation prospect and positive- although, still not guaranteed to materialize- supply considerations.

Anthony Karydakis