TIPS Issuance Sends a Powerful Message

• ByMarc Chandler, RealMoney Contributor
• On 1:00 pm EDT, Thursday August 6, 2009

As part of its quarterly refunding announcement yesterday morning, the U.S. Treasury indicated that is considering canceling the 20-year Treasury inflation-protected (TIP) security and reintroducing the 30-year TIP. The decision will be announced in November and auctioned in January 2010. TIP issuance is likely to increase next year.

Some observers seem to misunderstand what is going on. One strategist at a large bond house told CNBC to watch the direction of TIPS because it may have a bearing on U.S. government policy. Yet this is putting the cart before the horse.

In their discussions -- not only with China, which are played up in The Wall Street Journal, but with domestic investors as well -- Treasury officials likely learned what we learned from talking with our clients and a wide range of market participants: Either as an unintended consequence of the aggressive monetary and fiscal policy, or as conscious effort to reduce the debt burden, the U.S. faces a serious risk of inflation.

Our arguments about the slack in the factor markets (record low capacity-utilization rates, rising unemployment, lack of demand for credit) and the output gap, or that inflation expectations -- measured, for example, by the 5-year/5-year forwards that are higher in Europe (2.81% in France and 3.56% in the U.K.) than in the U.S. (2.52%) -- have not been sufficient to ease the inflationary worries.

U.S. officials have been clear -- they tend to accept the broad outline of the argument and will likely reiterate it in next week's Federal Open Market Committee statement. But taking a page from the game theorists, how can the U.S. officials drive home the point that they will prevent a sharp increase in inflation? Answer: Issue more TIPS and in doing so take on the inflation risk -- transferring it from the investor to the U.S. government.

On one hand, it may be seen as a negative that investors are concerned about U.S. inflation. On the other hand, it is positive that the U.S. has the depth and breadth of the capital markets to offer more inflation-protected securities. In some ways, issuing more TIPS is an extension of the Treasury's willingness to offer the type (including maturity) that investors want.

The U.S. Treasury seems sensitive to the needs and desires of investors. To be clear, although there will be much talk that the U.S. move is to appease China, many domestic investors have similar anxiety. Issuing more TIPS is part of the way officials can secure their "supply lines" of capital. Of course, because the current account deficit has fallen considerably, there is less need for foreign capital, but it is still important and the stock of foreign holdings remains considerable.

That some investors would be content to outsource the risk of inflation to the U.S. government suggests greater TIP issuance may reduce some pressure on the U.S. dollar. Behind many dollar bears' argument is the idea that the U.S. will debase its currency through inflation. The Treasury is saying, "We are so sure that inflation is not a problem and won't be a significant problem, we will take on the risk." So contrary to the beliefs of the analyst on CNBC, the performance of TIPS may not affect U.S. policy so much as U.S. policy is behind the likely shift toward more TIPS issuance.

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