ADVERTISEMENT

‘Fear Factor’ Reigns as U.S. Prepares to Sell Debt

‘Fear Factor’ Reigns as U.S. Prepares to Sell Debt

(Bloomberg) --

It’s a dicey time to sell bonds, but that’s how the U.S. Treasury Department rolls.

Measures aimed at shoring up liquidity in the tumultuous U.S. debt market face a key test Thursday when investors will be asked to pony up $12 billion in arguably the Treasury market’s most problematic corner -- inflation-linked notes.

While the entire $17 trillion U.S. government bond market has experienced sky-high volatility this month and there is talk about the administration potentially financing stimulus measures with ultra-long debt, the bottom has fallen out of Treasury Inflation-Protected Securities. Concern about a deflationary economic slowdown is acting as a drag and investors say it’s never been more difficult to trade them.

Under these conditions the government is selling 10-year TIPS, as per a schedule set in 2018. The auction at 1 p.m. New York time will be a reopening of an issue that debuted in January. Back then it yielded 0.036%, but it has since plummeted in price and this week it traded at a yield above 0.60%.

‘Fear Factor’ Reigns as U.S. Prepares to Sell Debt

“The fear factor is going to be very, very high,” said Gang Hu, managing partner at Winshore Capital Partners, who was a market-maker and investor in TIPS for most of his career from 2003 to 2013.

The auction shouldn’t fail, because primary dealers will place bids, though they are likely to be extremely cautious, Hu said. As a result, he said, the success of the auction will depend on demand from investors, including passive funds, which have grown.

But without strong buy-side demand, “you could see a tail larger than anything we’ve ever seen,” Hu said. A tail -- defined as an auction clearing yield higher than the market yield at the bidding deadline -- of 3 to 4 basis points will be “a success by anyone’s standard,” according to Hu.

The global economic and financial crisis caused by the coronavirus pandemic has drained liquidity from financial markets, including from Treasuries, the world’s deepest debt market. The damage has been particularly acute in TIPS, which have less liquidity than regular Treasuries to begin with. They also are sensitive to movements in the oil market, which this week saw West Texas crude collapse to as little as $20 a barrel.

‘Fear Factor’ Reigns as U.S. Prepares to Sell Debt

The crisis also has raised the prospect of a major expansion in Treasury issuance to fund fiscal stimulus that may exceed $1 trillion. Among other measures, U.S. debt managers -- who in January decided to resume issuing 20-year bonds this year -- are considering adding 25-year and 50-year issues as well, according to people familiar with the matter.

Meanwhile, Fed measures aimed at restoring Treasury market liquidity include ramped-up purchases from dealers of Treasury securities, including TIPS. On Tuesday, the central bank’s planned purchase of $3 billion of TIPS drew nearly $13 billion of offers. So far, it’s the only operation in which dealers offered more than four times the amount the Fed intended to buy.

On Thursday morning, the Fed increased the amounts of TIPS it plans to buy on Thursday -- after the auction -- and Friday to a cumulative $14 billion. That’s up from $10 billion when the purchases were announced on Wednesday.

To be sure, the sell-off in TIPS has cheapened the 10-year note by a margin that may appeal to investors. Its breakeven inflation rate -- the average annual inflation rate needed for it to match the performance of a regular 10-year Treasury -- declined to around 0.63%.

“There’s no question the reopening could be a challenge,” said Com Crocker, an investment strategist at New Century Advisers and former TIPS market maker from 2002 to 2017. But yields have soared, “and TIPS breakevens have reached levels which we think are attractive and should draw some interest.”

The TIPS market has been tested before. During the financial crisis, the breakeven inflation rate for 10-year TIPS fell from over 2.50% in July 2008 to negative 0.08% in November of that year.

In October 2008, a 5-year TIPS auction tailed by 13 basis points, while a 10-year tailed by 6 basis points, according to Michael Pond, head of global inflation strategy at Barclays Capital.

“A significant tail against the backdrop of uncertainty would not be a surprise,” Pond said. But uncertainty “can work the other way as well,” he said. In January 2009, with the breakeven rate still near 0%, a 10-year TIPS auction drew a yield nearly 10 basis points below the market’s.

Investors may look at depressed breakeven inflation rates as a bargain in the context of federal deficit and Fed balance-sheet explosion and loose monetary policy that “most economic models would say would engender inflation,” said John Brynjolfsson, who managed TIPS at Pacific Investment Management Co. for a decade. And if they don’t, TIPS also offer protection against deflation because they mature at par even if consumer prices are in decline.

“Getting your full principal back in a deflationary environment would be a home run for an inflation-indexed investor,” he said.

©2020 Bloomberg L.P.