Investor Concerns on Deflation Turn Treasury Securities into Negative Territory: Economist

The yield on 5-year US Treasury inflation-protected securities (TIPS) recently slipped into negative territory. The fall in Treasury yields bode well for the mortgage bond investment market. The declining yield on 5-year TIPS arrives as the 25 largest banks have been seen getting back into “attractive” mortgage-backed securities (MBS), in recent weeks adding the most MBS in 18 months. Although there’s no reason why the yield on 5-year TIPS could not fall further, economists anticipate a larger risk of it rising sharply on possible deflation, according to commentary today from Capital Economics. Although a standard explanation for the decline in yield is that investor fears of inflation are stoked — possibly because of rising Federal debt, which policy-makers could be tempted to “inflate away” — such an explanation seems unlikely. “But if this were the case, then the yield ought to have fallen by a greater amount than the yield on 5-year conventional Treasuries,” said senior markets economist John Higgins. “In fact the opposite has happened [see below].” Instead, it is more plausible that investors expect the Federal Reserve “to keep leaning with the wind.” However, if the yield on 5-year TIPS fell due to investor fears of inflation, it’s possible the yields could continue to fall below zero. In that case, the Fed would likely raise interest rates  — which would presumably push the yield on TIPS further along the curve. Deflation remains a larger risk as long as interest rates remain near zero, the firm said. Although investors in conventional Treasuries are “protected” by the zero bound on nominal yields, investors in TIPS are exposed to a bit more risk due to the cash flows of such bonds declining in tune with deflation. If expectations of deflation began to build with interest rates near zero, the realized real yield of TIPS held to maturity would equal their real yield at the time of purchase. But the nominal realized yield could be much lower — or negative — with deflation: “Even though we don’t expect investors to start pricing in a protracted period of deflation any time soon, we still think there is a considerable risk of a rise in the yield on 5-year TIPS from here,” Higgins said. Banks have been seen favoring mortgage bonds over Treasuries for the prospect of higher yields. As HousingWire reported, banks are historically big buyers of MBS and have the potential to absorb another $150bn of agency mortgages. In the midst of the passage of Dodd-Frank, banks fled to Treasuries, while parking cash in short-duration. This proved to be an expensive strategy, one that could be abandoned in favor of yield now that reform is passed. Write to Diana Golobay.