Yesterday was a big day in the world of TIPS (Treasury Inflation-Protected Securities). For the first time ever, the government auctioned off 5-year TIPS at a negative yield of 0.55%. In other words, people actually paid more than the face value of the bond. So why would investors do such a thing, and more importantly, what does it mean for you and me? Good questions, so let’s take a look.
First, investors have been anticipating for weeks that the Fed will initiate a second round of Quantitative Easing (QE). That’s the Fed’s fancy term for buying U.S. debt. Remember that of a bond and its yield (or return) move in opposite directions. So as the price of a bond goes up, its yield goes down. When the Fed moves in to buy U.S. bonds, it increases the demand for the bonds, raising the price and lowering the yield. In fact, that’s exactly why the Fed undertakes QE–to bring down interest rates.
Second, the Fed looks to bring down interest rates to stimulate the economy. In a “normal” economy, the Fed controls interest rates by raising and lowering the discount rate (the interest rate the Fed charges banks for short term loans) and the Fed Funds Rate (the interest rate banks charge other banks for short term loans). To stimulate the economy, the Fed lowers these rates. The problem today is that they are already near 0%. So to stimulate the economy further, the Fed looks to QE.
Third, when the Fed undertakes its next round of QE, interest rates should go even lower. Lower rates have significant implications for both investors and consumers. For investors, the yields on bonds will go even lower than they already are. A negative 0.55% yield may look like a steal. And lower rates generally spark a rally on Wall Street, which we are already seeing.
For consumers, lower rates are great for borrowers, but not so great for savers. We can expect mortgage rates to go even lower. The cost to finance or refinance a car will go down. And even 0% balance transfer offers on credit cards could become more generous. On the flip side, rates on high interest savings accounts could go lower than they already are. So for savers, it’s going to be harder and harder to find good interest rates.
Finally, low rates won’t last forever. One of the reasons investors are willing to buy TIPS at a negative yield is that TIPS pay a premium when inflation goes up. So if you believe, as these investors must, that inflation will eventually go up over the next 5 years, the current investment at a negative yield could still pay off nicely. And this is the key. Investors expect QE to work. They expect the Fed to successfully stimulate the economy, driving prices and employment up. When that happens, the low interest rates enjoyed by borrowers and despised by savers will start to rise.
The key is to prepare for rising rates now. So whether you need to refinance a mortgage or pay off some credit card debt, don’t wait until interest rates start to climb.
Published or updated October 26, 2010.