(MENAFN- Asia Times) Long-term US Treasuries have been 2016’s star performers with the 10-year Treausry yield falling from almost 2.4% last November to an low of about 1.53% on Feb. 11 when markets feared a new financial crisis. Since then the 10-year yield has retraced to 1.9%. It could move higher and investors who made profits in long-term Treasuries should be cashing out of the market.
Nothing should be simpler than a bond issued by the government of the world’s largest economy. Governments have way of making things complicated though. And governments make bond markets complicated by selling inflation-tracking securities. The US government sells Treasury Inflation Protected Securities or TIPS. At maturity the principal amount of TIPS is adjusted to the government’s Consumer Price Index. If you buy 10-year TIPS at a dollar price of $100 and the Consumer Price Index doubles the government pays you $200. In the meantime you receive a much lower yield than you would on ordinary Treasuries. TIPS yields frequent are negative: you might pay $102 for a $100 bond in the expectation that inflation indexing will more than compensate you.
Ordinary Treasuries yield more than TIPS. The difference between the TIPS yield and the ordinary Treasury coupon yield is called the “breakeven inflation” rate because that is the rate at which investors in TIPS and in ordinary coupon Treasuries earn the same yield.
Not surprisngly the “breakeven inflation rate” tracks oil and commodity prices as the above chart showing 10-minute interval data since October makes clear. The inflation rate that matters to TIPS investors is the CPI as measured by the BLS; this has been amplified increases in the cost of rental housing. Breakeven inflation has moved up a bit faster than the oil price during the past few weeks.
The TIPS yield though does not follow the oil price. Instead it tracks the price of gold quite closely in fact. This has been emphatically true during the past several months. It has also been true for the past nine years.
Why should this be the case? We can think of TIPS as an out-of-the-money option on inflation. As the dollar weakens the value of TIPS (the inverse of their yield) increases. At a certain point TIPS began to trade like an in-the-money option that is with a low delta (price sensitivity to the underlying).
The optionality embedded in TIPS becomes more transparent when we plot TIPS yields against the price of gold. The r-square of regression between TIPS yields and gold price since 2001 is 78%. Gold and TIPS both can be thought of as deep out-of-the-money puts on the dollar; the investor sacrifices income (in the case of gold) or relative yield (in the case of TIPS) paying as it were the premium on an option which will pay off in the event of serious monetary instability.
Investors have been paying up for deep out-of-the-money puts on the dollar during the instability of the past two months. The price of such insurance probably has peaked. If markets continue to calm down TIPS yields may rise while gold falls.
That’s a good reason to take profits now. Oil has snapped back reducing deflation risk and fears of a global financial crisis have receded. That means both components of the Treasury yield are likely to rise: breakeven inflation has already risen along with oil while TIPS are vulnerable to a reduced bid for catastrophe insurance.
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