There’s no indication the bond market is better now in figuring future inflation; its expectation of 2.4% average annual CPI over 10 years seems woefully low.
By Wolf Richter for WOLF STREET.
The US government sold $19 billion of 10-year Treasury Inflation Protected Securities (TIPS) on Thursday at a yield of 2.169%. The 10-year TIPS auctions occur every other month, six auctions per year. In secondary market trading, the 10-year TIPS yield ended on Friday at 2.16%.
This TIPS yield is paid in addition to the CPI-based inflation protection that TIPS holders receive and that is added to the principal and is paid when the TIPS mature. So the principal of the TIPS grows over time with CPI. The interest rate (the percentage is fixed for the term of the TIPS) is applied to the entire principal, including the inflation protection. As the principal grows over time with CPI, the interest payments increase, though the interest rate remains fixed.
If CPI inflation averages 3.5% per year over the next 10 years, these TIPS buyers will get a combined yield of about 5.66%. If inflation averages 2.0% over the next 10 years, the TIPS buyers will get a combined yield of 4.17%. You can see where this is headed: the bond market’s delusional “inflation expectations.”
The chart above shows that the TIPS yields went negative during QE when the Fed’s heavy-handed purchases of TIPS dominated the TIPS market.
The TIPS market is relatively small and not very liquid, with only $2.1 trillion in TIPS of all maturities outstanding, spread over 5-year, 10-year, leftover 20-year (issuance was discontinued in 2009), and 30-year TIPS. In this thin market, the Fed’s purchases of TIPS during QE pushed the TIPS yields deeply into the negative.
The bond market’s “inflation expectation” is the difference between the regular 10-year Treasury yield (4.56% on Friday) and the 10-year TIPS yield (2.16% on Friday).
If the bond market thought on Friday that average CPI inflation over the next 10 years would be 3.5% per year, the regular 10-year Treasury yield would have been 5.66% (inflation-protected yield of 2.16% plus average CPI inflation of 3.50% per year over the next 10 years).
But that’s not what happened. On Friday, the bond market figured that 10-year average CPI inflation would be 2.40% (regular 10-year Treasury yield of 4.56% minus the 10-year TIPS yield of 2.16%).
If the past is any indication, the bond market is delusional about future inflation.
In May 2016, the bond market figured that over the next 10 years, CPI inflation would average about 1.8% per year. As we know now, as these 10 years are up, actual CPI inflation over those 10 years averaged 3.2% per year (dotted purple line in the chart below).
In May 2021, after inflation had already begun to rage, the bond market still thought that over the next 10 years, CPI inflation would average about 2.4%. But over the first 5 of those 10 years, actual CPI inflation has averaged 4.5% per year, nearly double (light-blue line).
In fact, the bond market has been totally delusional about how high actual CPI inflation would be.
Buyers of regular 10-year Treasury securities totally underestimated actual future CPI inflation, and yields ended up being way too low compared to TIPS and way too low compared to actual CPI inflation, and those good folks got ripped off.
And there is no indication whatsoever that the bond market is any better now in estimating what future inflation will be, and its current estimate of 2.4% average CPI inflation per year over the next 10 years seems woefully low.
Which is why this observer is not touching 10-year Treasury securities at these yields – not even with a 10-foot pole.
The insidious effect of the Fed’s TIPS QE.
The Fed’s QE – when the Fed buys massive amounts of longer-term Treasury securities and MBS to push down longer-term yields and mortgage rates – is by definition a strong-arm method of outright, explicit, and much-hyped market manipulation.
But the Fed’s purchases of TIPS added an especially insidious side to QE. The Fed’s purchases of TIPS pushed down TIPS yields into the negative and created the deceptive perception that the market’s “inflation expectations” were “anchored” at very low levels – below 2% through 2021 – which Powell touted at his insidious press conferences in the first half of 2021 as rationalization why there was no need to end mega-QE or to raise rates, though inflation had begun to rage.
In other words, the Fed’s QE manipulated down its very yardstick that it used to defend QE and its ZIRP. This was the most reckless Fed ever (Google that phrase), and Powell was the architect of it.
But QT ended eventually that. And now there is no longer any excuse for the bond market to be this delusional about inflation.
Pouring a bucket of ice water on TIPS.
TIPS have nasty tax consequences. The inflation protection counts as taxable income. Each year, the inflation protection that was added to the principal during the year will show up on the 1099-INT for that year. And the coupon interest payments also show up on the 1099-INT. So TIPS trigger a tax liability every year for the inflation protection that won’t actually be paid until maturity, in addition to triggering a tax liability for the coupon payments that were actually paid, which is why TIPS remain unpopular.
And as is the case with other longer-term Treasuries, when yields rise, TIPS market prices decline, but due to the relatively low liquidity in the TIPS market, selling TIPS, especially in a hurry, might come with a nice haircut.
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