Closing Comments October 27 2008

October 27th, 2008 4:00 pm | by John Jansen |

Prices of Treasury coupon securities retreated from the lofty levels attained in overnight trading and are closing the session with moderate losses. The yield on the 2 year note has jumped 7 basis points to 1.60 percent. The yield on the 5 year note has climbed 7 basis points also to 2.65 percent. The yield on the benchmark 10 year note has edged higher by 5 basis points to 3.73 percent. The yield on the Long Bond has increased just 2 basis points to 4.09 percent.

The 2 year/10 year yield spread is closing the day at 213 basis points. That spread began the day at 219 basis points.

The interesting outcome in the Treasury market today was the result of the auction of $6 billion 4 year 6 month TIPS. For the uninitiated that stands for Treasury Inflation Protected Securities. The auction was rather sloppy as the auction tail was 14 basis points. (In bond market jargon the tail is the distance from the level at which bonds were trading on a when issued basis immediately prior to the auction, to where the Treasury was able to complete the sale. That long tail represents a lack of interest from clients and dealers who would normally underwrite the security.)

The average yield was 3.27 percent which means that the new bond yields more than the nominal 5 year note. The so called breakeven spread is the spread at which inflation would need to average for the holder of the TIPS to breakeven with the nominal bond and it generally predicts a positive rate of inflation.

In this case, the TIPS is yielding above the nominal bond by about 70 basis points in which case the market is saying that it thinks that inflation will average negative 0.7 percent per year for the next 4 ½ years.

There are some forecasters who have extrapolated from the drop in oil prices that cumulative inflation for the last 3 months of this year could be as much as -3.0 percent.

I would also reflect that the shoddy outcome is also a result of a lack of balance sheet and indicates the risk averse nature of the business at the current time.

The plain vanilla Treasury market still maintains an aura of dysfuctionality with many bonds in 2013 and 2015 still failing and still trading at Zero percent in repo.

The Treasury will auction $34 billion 2 year notes tomorrow and $24 billion 5 year notes later in the week. The forward rolls into those issues are unaccustomedly wide at 7 basis points and 8 basis points, respectively. The wide spread reflects the tight repo for the outstanding issues.

In terms of customer activity, there was hedge fund selling of 2 year notes at the lower yields this morning. End users from Asia were buyers of the 10 year note.

Agency spreads were wider across the curve with benchmark paper 5 basis point to 8 basis points wider Asian clients were better sellers . There was some selling by domestic clients in the 5 year sector and the only buying was in the 0 to 2 year part of the curve.

Swap spreads tightened 1 basis point to 2 basis points today.

Mortgages suffered the slings and arrows of outrageous fortune and are about 20 basis points wider to swaps. There were better sellers throughout the day. Liquidity is impaired and it is difficult to move large blocks.

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  1. 11 Responses to “Closing Comments October 27 2008”

  2. By y81 on Oct 27, 2008 | Reply

    I should know this, but I don’t. If CPI change is actually negative over the life of the bond, do the TIPS actually reduce principal and pay you less than the original face?

  3. By ndk on Oct 27, 2008 | Reply

    “When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater.” That’s what makes this pricing remarkably stupid.

  4. By y81 on Oct 27, 2008 | Reply

    I agree, ndk, that is stupid pricing. It must be due to other factors driving up the price of the nominal note? (I believe, when we don’t know what those other factors are, we refer to “technical” factors.)

  5. By Dave on Oct 27, 2008 | Reply

    John, thanks for including some definitions in your closing comments (like explaining “tail”). Greatly appreciated.

  6. By Oren on Oct 27, 2008 | Reply

    The deflation expectation calculation for the TIPs is off. Deflation, unless it’s huge, has a very small impact on the nominal return from TIPs, because they have optionality in the redemption value: the maturity value is the larger of the original face and the adjusted (in this case deflated) face. If there is cumulative deflation over the life of the bond, it affects only the coupons. Let’s say there’s 1%/yr deflation expectation on a 3% coupon bond. After 5 years, the nominal coupon will be down by roughly 15bp on the original face. Over the life of the bond, the average reduction in the coupon is roughly half of this – say 7 bp. So to get 5 year TIPs trading 70 bp wide of nominal bonds, you’d need to assume something like 10%/yr deflation expectation.

    As y81 says, this has to be due to something other than deflation expectations.

  7. By sasso on Oct 27, 2008 | Reply

    agree that the pricing is interesting but as far as being paid the greater of original principal or adjusted there is some risk since it’s a reopening and you’re paying an index ratio of 1.03666 which could potentially be marked back to 1.00 if deflation were to persist no?

  8. By Oren on Oct 27, 2008 | Reply

    Good point… There’s the 70 bp/year, plus a little bit. If the deflation expectation is enough to drive the factor to 1, the nominal yield goes down by 3.66/4.5 = 81 bp/year.

  9. By ndk on Oct 27, 2008 | Reply

    sasso, that’d be a hypothetical if this were happening in isolation. It’s across the curve, though (sorry). Check these real yields on 5’s:

    1.70% on 6/10/08, and 3.74% today. Not only is that 115 bps over nominal; it’s a major fork in the neck of the economy and every asset class out there. This butchers DCF calcs.

    I’ve been trying to think through what the “equilibrium” real interest rate is and how it would be changing now. It’s been between 1% and 5% in U.S. history, according to most estimates. Not that equilibrium is a relevant word these days…

  10. By ndk on Oct 27, 2008 | Reply

    Not only that, but during the heady last days of the commodity bubble (March 10th), the 5 year real yield dropped as low as 0.01%. We fail at counter-cyclical monetary policy.

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