TIPS are Negative but have Minimum Positive Coupons, huh?

Last week, Thursday April 21^st the Treasury Department sold an astonishing $14 Billion of 5-year Treasury Inflation Protected Securities at a yield of negative 0.18%. But since the government has place a minimum floor yield of 0.125% resulting in a yield gap between regular 5-year Treasury and the 5-year TIPS to be approximately 2.35% supporting the expectation that higher inflation is in cards. So with TIPS potentially paying higher yields as inflation fears increase the usual payoff comes as the 0.125% as is added to the CPI index. Below is a chart of the Barclays TIPS bond Fund index compared to the % gain of the S&P500.

http://www.marketwatch.com/story/treasurys-rise-before-unusual-tips-auction-2011-04-21?link=MW_home_latest_news

Are we on the Brink of Rising Rates

At the Commerce Street Capital LLC annual bank conference in Las Colinas, Texas on April 8^th the take away message was that banks need to evaluate their potential interest rate risk on their balance sheets. The bank’s CEO, Dory Wiley stated that since the sustained period of low interest rates many banks have become more liability sensitive thus squeezing deposit margins and shifting banks to shorten their durations of their portfolios. This type of activity if overdone can expose banks to income losses if rates rise.

As one solution presented were for banks to consider setting caps on loans to avoid borrowers becoming distressed when rates rise, as borrowers’ nature is to be liability sensitive. In Fact approximately 6.80%, or 445, of the 6,540 commercial banks in the U.S. were asset sensitive at Dec. 31, 2010, compared to 13.13%, or 820, of the 6,245 commercial banks in the U.S. at Dec. 31, 2006 as presented by Mr. Wiley. Although the hope for many institutions is that loan demand returns especially when the rates begin to rise but not as fast the 350 bps increased which this occurred after the last credit cycle in 1994.

http://www.snl.com/InteractiveX/article.aspx?ID=12605506

Why so low 3 and 6 month Treasury

The effects of the Dodd-Frank Act are beginning to have repercussions in the Treasuries market as U.S. banks began to hoard Treasury bonds thus putting a strain on the repo market. This strain was present on Friday April 8^th and Monday April 11 when the 6-month T-Bill touched an all time record low yield of 11 bps and the 3-month T-Bill touched a 13-month low yield of 3 bps.

This Treasury desert amounted to about $40 billion on Friday raising the anxiety level for future higher borrowing costs for money market funds and their respective investors. The rule was implemented by the FDIC on April 1^st and forced many large banks to refrain from lending out their Treasury Holdings thus eliminating bank arbitrage opportunities thanks to the plentiful Treasury bond supply constraint collateral from the Fed’s $600 billion bond buying program.

Before April 1^st banks would typically lend out their Treasury holdings in the overnight Treasury repo market and take those proceeds and leave them at the Fed which paid them some interest on the reserves. Some large banks would also borrow funds from GSE’s such as Fannie Mae or Freddie Mac in the Fed-Funds market and park them in the Fed to earn a little higher spread. Although, these unintended consequences seem to be short term while markets become accustom to the rule, this past week’s yield lows had some effects in profitability for large money market funds around the world.

http://www.reuters.com/article/2011/04/05/markets-money-idUSN0512901520110405

The FOMC likes firm foots in their minutes.

At the March 15^th FOMC meeting stated that the recovery is gaining strength and they plan to adhere to their $75 Billion in Long-Term Treasury bonds each month through June 2011. The chart below shows the Fed’s balance sheet composition over the past four years and although the minutes mention a tapering effect taking place in the purchase of Treasury securities the obvious effect is shown by the treasury yield curve steepening.

Although the Fed officials admit in continuing downside risk in the US housing market and the ramifications of the European fiscal adjustments their chosen word for economic growth is their belief in a “firmer footing.” The committee also expects economic conditions including low rates of resource utilization, subdued inflation trends and stable inflation expectations, to warrant exceptionally low levels for the federal funds rate for an extended period.

My concern is when the Fed planes their exist strategy, how do they plan to tackle the obvious inflation and unemployment situation. Just remember that even when the US was in an obvious recession back in Feb 2008 Uncle Ben stated that he doesn’t foresee any recession and that it’s simply a correction in the markets.

http://www.federalreserve.gov/newsevents/press/monetary/fomcminutes20110315.pdf