Short-Term TIPS Market Oversupply Could Lead to Stronger Long-Term Demand

The US is increasing its sales of treasury inflation protected securities (TIPS) in response to Chinese interest. While TIPS will remain a tiny market on comparison to the $6.66bn US government bond market, it looks like we could have $10bn in new supply flowing into a market which issued just $44bn in the nine months to June 2009. That's a lot of new supply in relative terms. The TIPS market fell on the news, no doubt due to fears of this potential oversupply, but might there be a positive angle to this development?

The Treasury Department, responding to growing demand from China and other investors, will boost the sale of inflation-protected bonds that hold their value as consumer prices rise....

Treasury officials need to ensure demand from China, the largest holder of U.S. government debt. Last week's auctions of fixed-rate notes saw lukewarm demand from China and other investors. Chinese officials had indicated they want inflation-protected securities, especially as the U.S. economy starts to recover...

Even with an increase, TIPS would remain a fraction of the overall market for Treasurys. Of the $6.66 trillion of government bonds issued between Oct. 1, 2008 and June 30 of this year, just $44 billion were TIPS.

The Treasury could easily sell as much as $10 billion more, said Jeffrey Elswick, director of fixed income at Frost Investment Advisors LLC. But those extra sales mightn't be such great news for existing owners of inflation-protected notes. If the Treasury continues to ramp up TIPS sales, it will "cheapen" the bonds of existing investors, said Don Martin, a financial planner with Mayflower Capital in Los Altos, Calif.

The value of the securities fell after the announcement, sending the gap between TIPS and comparable nominal notes to a two-month high. The gap ended at 1.93 percentage points, signaling that investors expect annualized inflation of 1.93% over the next decade.

Going forward, a larger and more liquid TIPS market could cause foreign government buyers to increasingly enter the market, allocating an increasing amount of their capital towards TIPS rather than plain vanilla US government bonds. It makes sense that they should fear inflation, and a large part of their investment in US debt is simply to park money in as risk-free a manner as possible.

TIPS meet this criteria better than plain bonds due to their inflation adjustment, but to date have been too small of a market for large foreign buyers such as China or Japan. A larger market would remove this problem and make TIPS plainly better at meeting the goals of those who wish to simply park their dollars in as risk-free a manner as possible. Thus while oversupply due to expansion of the market is a worry today, perhaps greater TIPS supply could beget greater demand from players which previously deemed themselves too big to take part.