Unabated fears of inflation and worries about the onslaught of new debt keep pushing up long-term yields.

By Wolf Richter for WOLF STREET.

The yield of 30-year Treasury Inflation Protected Securities (TIPS) rose to 2.91% on Thursday and closed at 2.87% on Friday, the highest since 30-year TIPS were reintroduced in February 2010, up from -0.6% at the end of 2021.

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 coupon 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.

The Fed’s lead-footed pandemic QE, which included purchasing a large portion of the TIPS in the relatively small TIPS market, pushed the 30-year TIPS yield to -0.6% by the end of 2021. When the Fed began tapering QE at the end of 2021 and then ended QE in early 2022, and then began QT in the second half of 2022, the 30-year TIPS yield took off.

TIPS are not very liquid because there are not that many outstanding compared to other Treasury notes and bonds. There are currently only $2.16 trillion in total TIPS of all maturities outstanding, 6.8% of total marketable Treasury securities ($31.8 trillion). The Fed completely dominated the TIPS market during QE and still holds $380 billion, or 17.6% of all TIPS outstanding, including the amount of inflation protection.

If CPI inflation averages 2.15% per year, which is what the Fed would like us to “expect,” today’s TIPS buyers would get a combined yield of about 5.06% (30-year TIPS yield of 2.91% plus CPI inflation protection of on average 2.15%).

And that long-term average of 2.15% CPI inflation is about what the bond market “expects,” as indicated by the regular 30-year Treasury yield, which is currently 5.06%, compared to the TIPS yield of 2.91%. So if inflation actually averages 2.15%, the TIPS and the regular bonds of the same maturity would produce the same return.

But if CPI inflation averages 3.5%, todays TIPS buyers would get a combined yield of 6.41%. If CPI inflation averages 1%, TIPS buyers would get a combined yield of 3.91%. In both scenarios, today’s buyers of regular 30-year Treasury bonds would still get 5.06%.

Long-term bonds are not for the faint of heart 💔

The regular 30-year Treasury yield closed at 5.06% on Friday, about where it had been a week earlier, despite the outlier CPI report on Tuesday. This yield is at the very high end of the range since its reintroduction in 2006.

In March 2020, as the 40-year bond bull market was flipping into a bear market, the 30-year Treasury yield had plunged to 1.0%, and briefly a hair below. And that was the bottom in yields.

When yields rise, bond prices fall, and for Treasury bond buyers at the time, these years since 2020 have turned into a bloodbath that caused the 2023 collapse of several regional banks that had believed what the Fed had said in 2020 and 2021 in its “forward guidance” that interest rates would remain near zero for a long time, and that QE would continue indefinitely. And these banks, including SVB, loaded up on very long-term Treasury bonds and MBS. And when the Fed changed its mind belatedly as inflation was raging toward 9%, and yields began to soar, the market value of the securities plunged and blew up the banks. And then the Fed and the government stepped in to clean up their own mess to avoid contagion to the rest of the banking system.

For example, the 30-year Treasury bond that sold at the Treasury auction in August 2020 (CUSIP 912810SP4) at a yield of 1.406% today trades at around 48 cents on the dollar. In other words, investors who bought at the auction from the government at the time and sold today would take a capital loss of about 52%.

But for buyers today, it looks different. Buyers in the secondary market today might pay about $480 for $1,000 face value of that bond issued in August 2020. And then every year until August 2050, they receive coupon interest payments of 1.406% of face value ($14.06 per year). And at maturity, they receive face value of $1,000. So in August 2050, they’ll realize a $520 capital gain in addition to the interest they collected over the 24 years ($337.44). This works out to a “yield to maturity” of 5.24%, as per online yield-to-maturity calculator. If a buyer ends up paying $500 for this bond today, the yield to maturity drops to 5.01%. But whoever bought it at auction in August 2020 from the government got hosed.

Treasury Yield Curve: bond market prepped for rate hike.

The chart below shows the yield curve of Treasury yields across the maturity spectrum, from 1 month to 30 years, on three key dates in 2025 and 2026:

• Red line: Friday, July 18, 2026.
• Gold dotted line: March 6, 2026.
• Blue dotted line: September 16, 2025, just before the Fed’s first rate cut in 2025.

As the gold line shows, the three rate cuts last fall pushed down the short-end of the yield curve. And on March 6, the market expected no rate hike at all, but a small chance of a rate cut, as the gold line at the 1-year to 3-year yields dipped below the Effective Federal Funds Rate (EFFR), which the Fed targets with its policy rates.

What the red line shows is that on Friday, the 1-month yield was still held down by the Fed’s current policy rates (3.50%-3.75%). But further out, the 6-month yield is now 30 basis points above the EFFR, indicating that the bond market expects a rate hike over the next few months, and then another rate hike next year, indicated by the 2-year yield. At the longer end of the yield curve, increased inflation fears have substantially pushed up yields.

Enjoy reading WOLF STREET and want to support it? You can donate. I appreciate it immensely. Click on the mug to find out how: