The gap in yield between the 10-year TIP (Treasury inflation-protected security) and the regular 10-year Treasury surpassed two percentage points, as investors begin to price in expectations of inflation (see WSJ article). This comes on the day that Federal Reserve Chairman Bernanke warns of how longer-term deficits are threatening the financial stability of the U.S., as yields on longer-term Treasuries and fixed-rate mortgages rise (see Bloomberg article).

U.S. 10-Year Treasury
Source: BigCharts.com

iShares Barclays TIPS Bond Fund
Source: BigCharts.com

In an effort to take advantage of increased investor interest in Treasuries, Pimco (Pacific Investment Management Company) is launching its first ETF, the Pimco 1-3 Year U.S. Treasury Index Fund (ticker TUZ, see MarketWatch article). The current Pimco ETF was developed for investors with a focus on maintaining stable principle with little or no credit risk. The new ETF is one of approximately 65 fixed-income exchange traded funds listed in the U.S., a small number compared to the much larger equity ETF universe. In addition to the new ETF, Pimco filed prospectuses with the SEC for six additional ETFs. Three of the new ETF will cover the 3-7 year, 7-15 year, and 15+ year Treasuries. The remaining three will be tied to the U.S. TIPS, including a general TIPS Index Fund, a short maturity U.S. TIPS Index Fund, and a long maturity TIPS Index Fund. The Pimco TIPS funds are expected to compete with the iShares Barclays TIPS Bond Fund (ticker TIP, see chart above). Such products will give investors betting on hyperinflation, such as Nassim Taleb (see previous post), a new vehicle for placing their bets.

Following the recent comments of Yale's endowment investment chief, David Swensen (see previous post), over half of a group of recently surveyed asset managers believe that high-quality corporate credit is currently trading at cheap levels and will likely rally in 2009 (see Financial Times article). Many feel that the rush to the safety of Treasuries has caused all grades of corporates, even high-grade bonds, to be oversold. On the other hand, many of the same analysts, including Pimco's Mohamed El-Erian, feel that US Treasuries will face considerable pressure after their recent fear-driven price appreciation, which in some cases drove yields to near zero levels for some shorter duration issues. Given the current desire by the incoming Congress and the President-elect to fund numerous public sector and infrastructure projects, the government will be forced to increase its issuance of debt, putting further pressure on Treasury prices.

As recently reported by IndexUniverse.com, in the last few months the yields on Treasuries have been rising, while yields on corporate bonds have been falling, signaling a shift from Treasuries to corporate bonds. But does this imply that investors are no longer worrying about the economy and therefore don't feel that they need the safety of Treasuries? Are investors simply sector shifting into corporate bonds? Closer inspection shows that while investment grade corporate bond yields have fallen recently (junk bond yields have fallen more), investment-grade corporate yields have actually remained relatively steady over the last year as Treasuries prices fell and their yields increased. Furthermore, even with the recent sell-off of Treasuries, the spreads between investment-grade corporate bonds and Treasuries is still above historical averages, signaling that there are still better deals in investment-grade corporates and that the sector shift is not complete. Rotation is also being suggested in part due to a belief that if Treasury yields do continue to rise, prices could fall much further and change much quicker than corporate bonds on average given that Treasury yields have been down so much in the last year, suggesting prices have gotten ahead of themselves.

There is a nice article over at the WSJ MarketBeat Blog discussing how the recent run of declining Treasury yields may be nearing an end. For the first time in about three years, the yield on the 2-year Treasury note is above the current federal funds rate of 2.25%. Maybe more important, the Treasury rate is also above the 6-month federal funds futures rate. Of course, a few days with a positive spread is good news, but it does not make a trend. Nonetheless, it is encouraging.

Does this bode well for the stock market? Can we assume that people are selling Treasuries and dipping their toes back into the stock market waters? Does this signal the end of the rate cuts, or at least imply that the best we can hope for is a 25 bp cut next week? Maybe, but maybe not. Investors are selling Treasuries, but it may be for reasons other than sector rotation. Given increases in inflation, yields on Treasuries are now low enough that investors are not being properly compensated for the risk of higher inflation. Furthermore, even with lower rates, Treasuries were attractive in a falling stock market if for no other reason than to preserve capital, even with low returns. When inflation increases and rises above your rate received, suddenly your buying power begins to decrease. As such, the recent move from Treasuries (to munis, money market funds, TIPS, corporates, equities - take your pick), may have more to do with inflation, and less to do with attractive new risk/return yields, at least in the short-term. If the spread continues to grow, we may begin to start feeling more confident that a shift in the market is occurring.