Longer TIPS and Shorter Nominal Notes

This should be a short post.  QE2 — for the most part, the Fed has bought shorter nominal (non-inflation protected) Treasury notes.  Now, we knew from the beginning that the Federal Reserve would buy the grand majority (94%) of its nominal bonds 10-years and shorter.  Also, 97% of the bonds would be nominal, and only 3% TIPS.  That makes some sense, because the Treasury bond market has an average maturity of around 5 years, and the Fed’s intended purchases of nominal bonds work out a little longer than that, at 6.5 years.

With TIPS the Fed left itself free to do whatever it wanted with respect to maturity.  So far, the NY Fed has done ten purchases of TIPS — $16.1 billion worth, which would indicate they are 89.5% of the way to their (perhaps approximate) $18 billion dollar target.  Let me summarize in a graph the purchases of TIPS to date, together with the targets for nominal Treasury purchases:

Average maturity for TIPS purchases is 14 years, versus 6.5 for nominal bonds.  As you can see in the graph, below seven years, more nominals are bought than TIPS, and vice-versa above seven years.  TIPS purchases are also concentrated in on-the-run 10- and 30-year bonds, which constitute 37% of all TIPS purchased.  On-the-run bonds are the ones most recently issued, and more actively traded.  They may have a disproportionate effect on the market as a whole.

What are we to make of this?  It’s not as if the Fed is avoiding longer nominal bonds; their purchase profile is longer than that of the Treasury market as a whole.  But with TIPS, the Fed is buying a disproportionate amount of the long end.  Why?  Possible reasons:

1) Maybe the Fed is no brighter than the average schmo,  and can’t bring itself to buy many bonds with a negative yield versus the CPI.

2) Perhaps the Fed anticipates higher inflation in the distant future, and is purchasing a small hedge.

3) Maybe the Fed is trying to make long-term inflation expectations look high, for reasons that are not obvious to me.

I lean toward reason 2.  Reason 3 is dumb.  Reason 1 is too easy; the Fed has made so many errors in the past — but that doesn’t mean that will continue to do so.

The correct answer is not known with certainty; the main thing I want to highlight is that the Fed is disproportionately purchasing long TIPS.  If you can tell us why, please comment so that we all might benefit.

8 Comments

  • davidmanheim says:

    Maybe this is a trivial observation, but if the spending continues, we are in the situation you pointed out: default, inflation, or higher taxes. inflation is the politically easy choice, and if the fed takes the right bet about inflation, it could be much cheaper for them to inflate.

    Of course, the size of the hedge as compared to the balance sheet may be minuscule; despite this, couldn’t it be a way of making inflation cheaper and an easier option? Do they have some non-obvious motive to prefer inflation to the other options?

  • wsm says:

    @manheim:

    Why are those the only 3 options?

    The ‘spending continues’ because of a mathematical identity that can be no other way; namely the balance of trade.

    With the private sector net saving and the balance of trade in a deficit position, the only possible outcome is public sector deficits. It can be no other way.

    But if you actually think about what is necessitating this condition, it is the massively DEflationary forces of toxic assets approaching their fair values (close to zero) while the private sector gets its balance sheet into closer alignment with incomes.

    Thus, I am not convinced that significant inflation is even one of the more probably outcomes.

  • wsm says:

    probable*

  • davidmanheim says:

    @wsm

    I understand the concern about toxic assets; my limited understanding was that the write-offs that occurred during the crash, in addition to banks hoarding cash and not lending at pre-recession levels had corrected for the vast majority of the difference. Again, my sense od scale could be off; we had a lot of value destruction occur in housing prices, maybe the liquid assets like Helocs that are based on these houses are a multiple of the write-offs, which would be massively deflationary. I don’t know. I don’t have the data I’d like in order to find out.

    But the US gov’t has spent (read:printed) trillions of dollars in the past couple years, between QE and war spending. That money exists now, even if it is borrowed from the future.

    And re: mathematical identity, from a great point I read somewhere recently, low interest rates are effectively borrowing from the future, high interest rates are lending to the future. This is a neglected input from your model. We keep rates lower than they “should” be, and accumulate future debts. Those get paid off, and as earlier, there are only three ways to do so. Once rates are high enough, the economy slows down to a point where real wealth, instead of financial manipulation, can be built. (At a point above the current rate, but possibly below the real wealth creation level, we enter into another recession. Glad I’m not in charge.)

  • Greg says:

    The Fed *staff* is worried about inflation, even if the FOMC politicians say they are not.

    CPI has not been negative for more than a couple months since the early 1930s. Whatever your macro econ professor’s models suggest, we are not seeing any actual deflation (housing prices reverting to the mean is not deflation).

    Even if we ignore all the statistical issues with CPI — CPI change has been positive from 2000 to present, and from 2007 to present.

    In Japan, their HCPI from 1990 to December 2010 averaged +0.3% per year. The plus sign is inflation.

    One indisputable sign that an economic model is wrong is when the model forecast clashes with actual observations. Actual observations show the cost of living continues to rise, and if anything the yoy increase is accelerating

    No country has ever printed money and ended up richer as a result. Every country that has printed large amounts of money has seen inflation. This time will not be different

  • davidmanheim says:

    @Greg

    I like the way you put that: “Indisputable sign that an economic model is wrong.” It’s almost like it’s a science with falsifiable theories!

    But… the cost of living is higher? It depends on where you live and what you buy; that’s why we use statistics. That’s not to say CPI is good. It’s a poor proxy for what we need it to do. And it doesn’t reflect what everyone needs – partially because everyone wants it to measure different things. For me, life’s been getting cheaper – but that’s because I’m moved in to my new apartment and my costs for furnishing it are gone, I am not paying for gasoline, and I don’t eat out as much now that I’m married, not dating. For you, it seems costs are going up. Most prices move chaotically in the short term, and trends are hard to see without math. (Or even, frequently, with it.) Energy costs fluctuate, but have been on an upswing. Many things are getting cheaper, including some food.

    I guess what I’m saying is, I’m not so sure. But I like your approach, and that you disassociated the Staff of the FOMC and the public pronouncements/politicians.

  • Greg says:

    @davidmanheim

    If you want to lie with statistics, CPI (NSA used for TIPs) was 210 back in late 2007 when the credit bubble popped, and the most reading was 221.3. That is an increase, aka inflation, period.

    http://research.stlouisfed.org/fred2/graph/?chart_type=line&s1id=CPIAUCNS&s1range=5yrs#

    While there have been a handful of incidents lasting a few months, but over the length of a TIP note CPI has not declined in decades (not since FDR canceled the gold standard in 1934).

    Now that Bernanke is printing money like a banana republic monkey, there is no chance we will see deflation in the near future. Deflation is a lie

    BTW … Just saw an interview with the CEO of Wal-Mart. He sees higher inflation too.

  • John says:

    Have you checked the volume of TIPS issuance and broken it down by maturity? After the initial offering, inflation indexed bonds don’t change hands as often as nominals, so TIPS purchases may naturally tilt towards on-the-run bonds. It’s possible the Fed is just buying whatever the Treasury has recently offered… that might be why they’re so heavy on 10-year notes, as those are the most frequently auctioned.