Whatever Happened to the Inflation Premium on 30-year U.S. Treasury Bonds?

By the Curmudgeon

Overview:

Last Thursday, the U.S. Treasury sold $19 billion of 30-year T-bonds [1.] at a 2.06% yield. That was below the previous record low yield of 2.170% set last October, according to data from BMO Capital Markets. On Friday, the 30-year T-bond yield closed at 2.04% and was trading at 2.02% on Monday afternoon when this article was written.

Image result for chart of banks holdings of 30 year treasury bond

Meanwhile, the Consumer Price Index (CPI) for All Urban Consumers (CPI-U) increased 2.5 percent over the last 12 months to an index level of 257.971 (1982-84=100). For the month, the index increased 0.4 percent prior to seasonal adjustment.

Combining those two data points and you get a negative real yield of -0.46% (-46 bps) on the 30-year T-bond, based on Friday’s close. To the best of my knowledge that has never happened before, yet no journalist has called attention to it.

Note 1. In 1974, 25-year T-bond issues became a regular feature of Treasury’s mid-quarter coupon refunding. In 1977, 30-year T-bond issues replaced the 25-year T-bond issues.

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Defining the Inflation Premium:

Ever since 25 or 30-year T-bonds were auctioned, there was an inflation premium [2.] of three to five percent (depending on the direction of inflation and bond market volatility) built into the nominal yield.

Note 2. The inflation premium can be estimated as the difference between the Treasury bond yield MINUS the yield of Treasury inflation-protected securities (TIPS) of the same maturity. Inflation Premium = Yield_TB – Yield_IP

Where Yield_TB is the yield on a Treasury bond and Yield_IP is the yield on Treasury inflation-protected security of the same coupon rate, redemption value, maturity, etc.

If we already have a nominal rate and a real rate, we can isolate inflation risk premium using the following equation:

Inflation Premium =	1 + Nominal Rate	− 1
	1 + Real Rate

There is also a maturity premium (e.g. the difference between the 30-year Treasury and the 10-year Treasury yields). Because the interest rate risk is greater for the 30-year Treasury, investors demand a maturity premium over a shorter duration bond to compensate for that risk. Lately, the maturity premium has been shrinking as the 30-year T-bond yield has dropped faster than the 10-year T-note yield.

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Now it seems the demand for U.S. long bonds is so voracious that buyers don’t mind losing purchasing power by holding a long T-bond for 30 years. Alternatively, the bond market may be forecasting zero inflation (or deflation) for the next 30 years. Or T-bond traders are expecting even lower yields so they can sell bonds purchased today at a profit tomorrow?

“I expect the Treasury 10-year yield to fall to zero, perhaps within two years,” said Akira Takei, a global fixed-income fund manager at Asset Management One Co., which oversees more than $450 billion. “I’ve been overweight U.S. Treasuries. That’s based on my view that developed economies are facing a combination of aging demographics and falling birth rates, slow growth and low inflation.”

Where is the Demand for Long T-Bonds Coming From?

· Pension funds have been ramping up bond allocations for more than a decade after a change in regulations. They now hold a record amount of longer-dated Treasuries.

· Bond mutual funds saw a historic inflow of money last year, with no sign of a slowdown. In the week ending February 12^th, Taxable Bond Fund Inflows were $11.7 Billion.

· Banks are buying record amounts of Treasuries [3.] as they scale back their lending. For example…..

· The Financial Times reported in November that JP Morgan Chase had bought more than $130 billion of long-dated bonds and cut the amount of loans it holds, marking a major shift in how the largest U.S. bank by assets manages its enormous balance sheet. The twin moves, which have seen the bank’s bond portfolio increase by 50 per cent, are prompted by capital rules that treat loans as riskier than bonds. JP Morgan’s new approach comes down to an economic decision: they can make more money selling [loans] than buying them. “It’s incredible,” said an executive at a large institutional investor. “The scale of what JPMorgan is doing is mind-boggling . . . migrating out of cash into securities while loans are flat to down.”

Note 3. On August 29, 2018, Zero Hedge reported:

…banks aren’t required to mark government securities to market for accounting purposes. Throw in the zero risk-weighting for government securities in required capital calculations, and in theory, banks can “infinitely buy government bonds and still not have to put up additional capital.”

In other words, heavily skewed regulations have gifted banks the proverbial money machine. And by cranking that machine, the banking sector has become a gigantic and somewhat price-insensitive government bond buyer, one on which the Treasury Department can depend even as debt spirals higher.

Victor had first noted these new rules for banks in this article, which was subsequently republished at Zero Hedge. This is the part I liked best:

The really interesting part is skirting around mark-to-market accounting. Since the banking crisis, banks have been permitted to hold assets in a special account called an HTM (held to maturity) account. Government debt held in this account is not marked to the market.

So even if interest rates rise and the prices of the bonds fall, the bank reports no decline in the value of the debt, which means no negative effect on quarterly earnings. But it still gets to collect the interest.

· While the Fed continues to buy T-bills at a rapid clip (see last week’s post: Curmudgeon: Fed T-Bill Buying Persists Despite Ultra Easy Financial Conditions), it is not buying long term Treasuries at this time.

· China has steadily accumulated U.S. Treasury securities over the last few decades. As of May 2019, China owned $1.11 trillion, or about 5%, of the $22 trillion U.S. national debt, which is more than any other foreign country.

Buy the Dip Mentality Extends to Treasuries:

With U.S. long term treasuries at or near all-time lows, buyers are still buyers ready to pounce and buy every dip (see chart below). Even surging stocks, record auction sizes and the tightest labor market since the 1960s can barely make a dent in bond prices.

Investors have been buying on dips in Treasury prices

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A Global Fixed Income Perspective:

Investors’ apparently hunger for ANY positive nominal yield in a global market with nearly $14 trillion of negative-yielding debt. It could also be a sign that some investors are hesitant to take on additional risk until they know more about the potential spread of coronavirus.

“The demand for (Thursday’s 30-year T-Bond) auction was amazing considering the low coupon,” Simons and McCarthy wrote in a Thursday note. “However, yield is hard to find around the world.”

The appetite for debt has extended to sovereign obligations of all flavors. One example: Greek 10-year rates once near 45% slid below 1% this month. The country’s junk rating is proving little deterrent with the world’s pile of negative-yield debt climbing above $13 trillion amid the latest global bond rally.

Closing Quote:

“Low yields may well be a sign that bond markets are correctly priced for the likely risks posed by the virus outbreak,” wrote Gaurav Saroliya, director of macro strategy with Oxford Economics.

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Good luck and till next time….

The Curmudgeon
ajwdct@gmail.com

Follow the Curmudgeon on Twitter @ajwdct247

Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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