TIPS Yield Curve fully inverted

Investment Analysis Clubs Macro Economic Trends and Risks
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The Treasury yield curve has been mostly inverted for several months.

10-Year Treasury Constant Maturity Minus 3-Month Treasury Constant Maturity (T10Y3M) is deeply negative, the lowest it has been since the 2000 dot-com bubble burst.

This is a clear indication of an approaching recession.

All METARs know that the Federal Reserve has been manipulating Treasury yields for years by buying massive amounts of Treasuries (up to 40% of the 10YT at some auctions). The Fed also buys TIPS. As the 10YT yield was suppressed, the Fed suppressed the TIPS yields at the same time to maintain a 10-Year Breakeven Inflation Rate of 2.0 to 2.5%.

When the Fed suppressed the 10YT yield to close to zero they also suppressed the 10Y TIPS yield to negative to maintain this constant gap. The 10Y TIPS yield was negative in 2012-2013 and also in 2020 to April 2022.

When the Fed started reducing its bloated book of long-term Treasuries by roll-off, long-term Treasury yields started rising in 2022. Longer-term bond yields have been falling since early November, a sign that the bond market believes that the Fed will be able to control inflation in the medium to long term.

Investors in long-term bonds need to consider the impact of inflation. The Fed (and the market) were blindsided by inflation. The real yield of $Trillions of bonds is now negative – and will stay negative until the Fed reduces inflation to their target of 2%.

TIPS investors are compensated for rising inflation since the principal of the bond is increased along with the CPI. An investor who buys a secondary market TIPS will pay more than par since they are paying the previous owner for the inflation increase of the bond’s value.

The TIPS yield curve shows the market’s expectation of future yields. The TIPS yield curve is fully inverted.

5-month TIPS are yielding over 3% (plus inflation). 3-year TIPS and later are yielding 1.5% and less. This is a pretty good yield for TIPS which hasn’t been seen since 2010.

It’s normal for long-term bonds to have an inverted yield curve during recessions. That’s why bond traders like recessions, because the value of their bond holdings increase when bond yields fall.

I think that inflation may turn out to be harder to control than the bond market has priced in. I also think that the Fed may return to suppressing long-term bond rates as it has before (QE) if the coming recession turns out to be more severe than they can accept. (Fed Chair Powell has said to expect some pain, but he wasn’t controlling the Fed during the nasty recession of 1980-1982 which had high unemployment that lasted a long time).

I think there is a real possibility of 1970s style stagflation. There have already been labor strikes which led to substantial pay raises.

For this reason, I just bought TIPS maturing in 2029 yielding 1.5% (plus inflation). Even if inflation does return to 2% (which I don’t think will happen fast) that would compare with a Treasury yield of 3.5% which is higher than it has had for 10 years (except for the spike over 4% in October 2022).

Wendy

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This is something that I can’t quite understand. How does a long-term bond roll off exactly? Doesn’t roll off mean “matured and not purchasing a new one”?

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Yes, which is why with the decreased demand in the market, prices fell and yields rose (regardless of inflation). The asset (the bond) “rolled off” the balance sheet like a piece of fruit rolling off the table.

Relevant snip:
…the Fed stopped reinvesting up to $30 billion in maturing Treasuries and $17.5 billion in maturing MBS every month, passively shrinking its assets as those securities “roll off” without being replaced. Those caps are scheduled to rise to $60 billion and $35 billion, respectively, in September.

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Right. So how does a 10-year bond “roll off”? By the time it rolls off, it’s a much shorter bond. Or are you referring to 10-year bonds that the fed purchased in 2012?

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The govt issues a wide range of bonds, with a variety of due dates. Thus, buying a range of older, low-yield, bonds on the open market could be cheaper than buying new long-term/higher yield bonds today. The book value of the old, low interest bonds goes up as maturity approaches–and the Fed would hold until maturity.

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Yes, of course. But if sometime during 2021, the fed bought a 10-year bond that was issued in 2012, it isn’t a 10-year bond that they bought, it is the equivalent to a 1-year bond. When the fed buys “a 10-year bond” in order to affect the 10 year rates, they need to either purchase a new issue 10 year bond, or an old 30 year bond with 10 years remaining on it.

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Here are Fed assets.

https://fredblog.stlouisfed.org/2017/02/lets-do-the-twist/?utm_source=series_page&utm_medium=related_content&utm_term=related_resources&utm_campaign=fredblog

" In September 2011, the Federal Reserve’s Open Market Committee (FOMC) announced a “Maturity Extension Program” involving the purchase of $400 billion of longer-term U.S. Treasury securities and liquidation of an equivalent amount of shorter-term securities over a 9-month period. In June 2012, the FOMC extended the program through the end of 2012, a period when the Committee purchased an additional $267 million of longer-term securities and liquidated a similar amount of short-term securities. The purpose of the program was to put downward pressure on longer-term interest rates without increasing the total size of the Fed’s securities portfolio. The program was popularly referred to as “Operation Twist,” reflecting the Committee’s intention to lower long-term interest rates relative to short-term rates and thus twist the yield curve."

Re-creating this chart is a lot of work which I don’t feel like doing. But it’s clear that the Fed can and did do a “reverse Operation Twist” where they are reducing their holdings of long-term debt relative to short-term debt to deliberately allow the long-term yields to rise. At the same time as the entire yield curve shifted upward, the Fed raised the fed funds rate so the yield curve inverted.

The Fed’s manipulations have lots of moving parts.
https://www.federalreserve.gov/monetarypolicy/bst_table1popup.htm

https://www.newyorkfed.org/markets/domestic-market-operations/monetary-policy-implementation/treasury-securities/treasury-securities-operational-details

The Fed Is Shrinking Its Balance Sheet. What Does That Mean?

While the Fed has experience buying assets to respond to crises, questions remain around unwinding those actions

By Tim Sablik, Federal Reserve Bank of Richmond
In response to inflation running well above its long-run target, the Fed began unwinding its accommodative monetary policy in 2022. This entailed ending QE in March and then beginning QT in June. When QE ended, the Fed reinvested any maturing securities to maintain the size of its balance sheet. With QT, the Fed stopped reinvesting up to $30 billion in maturing Treasuries and $17.5 billion in maturing MBS every month, passively shrinking its assets as those securities “roll off” without being replaced. Those caps are scheduled to rise to $60 billion and $35 billion, respectively, in September. …

As the Fed allows maturing securities to fall off the asset side of its balance sheet, it shrinks reserves on the liability side by an equivalent amount. At the same time, because the Fed is no longer purchasing Treasuries and agency MBS, private markets need to absorb more of those assets. This can result in some volatility as investors adjust. … [end quote]

Wendy

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Notes on 1947 and then on 1980. The FED notes on the 1947 period are important. The chart in the Forbes article is telling.

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@Leap1 thank you for sharing the Federal Reserve memo, which discusses earlier Fed policies to put a cap on long-term interest rates. These caps only lasted a short time and cost the government money (since Treasury made bondholders whole on their losses).

Because the direct management of the entire yield curve has a large and direct impact on the Treasury’s financing costs, it increases the scope for conflict between the central bank and the fiscal authorities. QT has already raised long-term Treasury yields but only compared with the Fed’s ZIRP policy that artificially suppressed them, not when compared with historical Treasury yields.

Wendy

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The main equivalency for our purposes is 1948 v 2023. The 1980 inversions were the ship turning to supply side econ. Now we need to map demand side econ.