Treasury's Debt Plan: More Sales of TIPS ~ Steve Blitz Morning Notes
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Wednesday, August 5, 2009

Treasury's Debt Plan: More Sales of TIPS

If you need any indicator that inflation will be the least of the problems policy makers are going to face in the near future it is --

The Treasury Department, seeking new ways to help fund its budget deficit, is likely to announce on Wednesday a plan to ramp up sales of inflation-protected bonds, according to people familiar with the matter.

China, the largest holder of U.S. government debt, is among investors that have indicated to the Treasury that they want to buy more of the securities, which offer protection against rising inflation, the people said.

China is obviously the main motivation for the Treasury to issue TIPs, and hopefully Treasury won't have to return to Carter bonds (U.S. debt denominated in another currency). Later in the article the WSJ moves into analysis and gets it a bit wrong --

Boosting issuance of TIPS would be one tool the Treasury could use as part of its broader debt-sales program. The government will have issued a record $1.8 trillion of debt in the 12 months through September, most of which was debt that pays a fixed interest rate, unlike TIPS, which pay out more as inflation accelerates. . . .

. . . . Demand for the securities is likely to increase as the economy improves and heavy federal spending on priorities such as health care push prices higher. It also would leave taxpayers on the hook for elevated interest payments if inflation remains high.

That isn't exactly true unless the Federal budget has moved to accrual accounting. TIPs carry very small coupons, smaller than the coupons on regular issues of similar maturity because the coupon on TIPs is effectively the "real" interest rate while the coupon on regular debt pays the real rate plus an inflation premium demanded by the market.

TIPs produce a stable real return for its holders because the prinicpal adjusts with the rate of inflation as measured by CPI - not seasonally adjusted. The fixed TIPs coupon pays interest on the inflated principal and the inflated principal is due at maturity. If inflation is higher then the government pays out the same real dollars in coupon payments. The principal is now being adjusted downward because of CPI deflation (food and energy are included). If there is inflation new regular debt will come with a higher nominal coupon -- so the Treasury pays more that way as well.

As for the inflated principal owed at maturity (between now and then buyers and sellers pay each other the accrued inflation premium when trading) the Treasury will issue more debt to pay off the TIPs at that time -- issuing the same real amount they are issuing today. So, in fact, TIPs are at best a cheaper source of financing for Treasury than regular bonds and at worst TIPs cost Treasury about the same.

The article goes on --

After the tepid response to auctions of fixed-rate bonds last week, Treasury officials asked some primary dealers whether they would be amenable to a new issue of 30-year TIPS -- which haven't been sold since October 2001 -- instead of five-year or 20-year TIPS, according to people familiar with the matter.

Demand for TIPS auctions this year has been robust, with last week's $6 billion reopening of 20-year TIPS garnering the highest demand in two years. The TIPS didn't entice only traditional Treasurys investors, but also those investing in stocks and commodities.

Everyone usually isn't right and the events of the past several years have proven that markets aren't particularly efficient or rational. If there is one constant, however, it is that market participants have been consistently awful at pricing future inflation. But if the Treasury can tap a cheaper source of funding, whom am I to argue.


  1. Glenn Maguire, Asia Chief Economist at Societe Generale, has just published a piece saying China is about to move into substantial trade deficit - in fact he argues, it is the logical performance indicator of a policy goal to switch external demand to domestic demand.

    Powerful stuff - he estimates the 2010 China global trade deficit in excess of USD100bn - the slowing accumulation of China's FX reserves, indeed the reversal, may be a shock for BOND markets - a NEGATIVE shock. Real yields need to be higher to substitute for non-Asia central bank buying.

  2. Not sure that I believe China will become a trade deficit nation and a huge one at that. But if that comes to pass, China as a net purchaser of the world's goods and services is a boon to these countries. Also, trade is a zero sum game -- if China is in deficit, someone else is in surplus (the U.S. ?)

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