Excellent TIPS Commentary: Illiquidity Reigns (Or Rains)

November 9th, 2009 10:48 am | by John Jansen |

Early Oscar alert! Get ready to be bombarded with ‘Precious’, a movie who’s unlikely heroine finds hope despite being forced into a life of utter despair. Unlike the bond markets, Hollywood still promises a happy ending.

I bring this up after last weeks events in both the TIPS and bond markets. After months of illiquidity and exaggerated price movements, the Treasury had a chance to provide a glimmer of hope to a downtrodden TIPS market. Unfortunately, the script writers at the Treasury must be on strike, because no happy ending was delivered. Instead of listening to virtually every market participant and finally providing some significant supply relief, the Treasury instead chose the path of glacier movement. No changes to the 5 and 10 year auction calendar, just a switch from 20 to 30 year TIPS. To add insult to injury, the late January auction was moved to Feb. 22. If events unfold as expected, all the money allocated to TIPS at year end/ beginning of 2010 will be greeted with even LESS January supply!

The result of these inactions was obvious. Oversized moves in breakevens on fairly light volume. But a more subtle and hopefully unintended result was the popular conclusion that inflation expectations are rising. The challenge for the market (and the Fed) is going to be separating the supply effect out of the breakeven numbers. Ironically, the Treasury is artificially making breakevens wider, which in turn raises inflation fears, which in turn raises nominal rates and increases borrowing costs.

A similar but less exaggerated phenomenon is occurring in the long end of the nominal market. The popular explanation for last week’s selloff was the inflationary implications of the Fed’s lower for longer policy and of their bloated balance sheet. I’m skeptical. The short term inflationary data appears to be fairly benign, and the inflationary effect of the Fed’s balance sheet without renewed bank lending is unclear. The challenge remains stripping out the supply effect on moves in 30 year yields. The 1-2 punch of increasing 30 year supply and the end of Treasury Buybacks is weighing on 30 year yields. Throw in the memory of last month’s bond debacle, and it should come as no surprise that a healthy concession must be built in to auction this week’s bonds.

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