Why rising inflation expectations caused the TIPS market to rally last week
The 10-year Treasury TIPS auction
On Thursday, May 22, the Treasury auction of its 10-year Treasury inflation protected securities (TIPS) drew the highest TIPS auction demand in two years—indicating that investors have started positioning their portfolios for an uptick in inflation.
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The $13 billion offering of sovereign securities drew enough attention from investors to gather enough bids to cover its sale by 2.91x, making it the strongest demand for TIPS since May, 2012. The securities were sold at a low yield of 0.339% (plus inflation)—down from a 0.659% in its previous auction in March. This happens to be one of the lowest rates demanded from the government.
Popular exchange-traded funds like the iShares Barclays Treasury Inflation Protected Securities Fund (TIP) and the iBoxx 3-Year Target Duration TIPS Index Fund (TDTT) are invested into Treasury TIPS securities.
Inflation leads demand for TIPS
Rising inflation expectations have led to a rally in the TIPS market, which has outpaced the nominal Treasuries market. The nominal Treasury market hasn’t seen much change in yield. However, the yields for TIPS, which are already lower than nominal Treasuries (when comparing across same maturities), reduced further down, as a result of the increased demand for inflation-protected securities, even at lower yields. As a result, the yield-gap between these 10-year TIPS and nominal Treasury has widened to 2.20% from 2.17%. This also means that bond investors see inflation averaging at 2.20% over the next ten years.
Inflation is one of the major causes for interest rate fluctuations in the economy. Certain exchange-traded funds (or ETFs) like the ProShares Investment Grade-Interest Rate Hedged ETF (IGHG), which has its major holdings in companies like Citigroup Inc. (C) and JP Morgan Chase & Co. (JPM), and the SPDR Barclays Capital TIPS ETF (IPE) are designed to protect the investors against interest rate risk caused by inflation.