The FRNY has already de facto replaced the risk-assumption function hedge funds provided until last year.  Now the Treasury wants in on the action.  From the Treasury’s morning release of the TBAC Minutes:

 The presenting member then discussed interest-rate volatility. Both realized and implied volatility remained at elevated levels relative to historical norms, with long-term rate volatility significantly higher than front-end rate volatility. The negative convexity profile of the mortgage market has increased with the QE purchases but it is difficult to hedge the convexity in the current market. This is because there are no natural sellers of volatility left in the market, following the collapse of hedge-fund capital, despite overwhelming demand for volatility from mortgage servicers and originators; this has created a chronic structural net short position in the market place. The presenting member suggested that Treasury, if it wanted to be opportunistic, could potentially benefit from this demand for volatility by offering putable issues.

So the Treasury would issue a security that it would agree to buy back at a fixed discount to par, thereby establishing a ceiling on its yield and a floor on price.  Sign us up.  Why would we ever buy regular Treasuries again?

Some thoughts on the TIPS (inflation linked securities) statements in the Minutes are below. 

The Committee then moved on to the second item in the charge concerning Treasury inflation-indexed securities. Specifically, Treasury asked the Committee if there were any changes to the TIPS program that Treasury should consider in order to improve TIPS market liquidity and maximize the diversification benefits of inflation-linked debt issuance.

The presenting member began the presentation by noting the original reasons given for issuing TIPS. Considering lowest cost over time, the presenting member noted that much of the criticism of TIPS has been based on ex-post cost measures which have shown a high cost. The presenting member also conceded that TIPS had not diversified the investor base to the point expected, but noted that some new investors to the asset class had recently been observed.

The presenting member remarked that lowest cost over time and the diversification of the investor base were not the only goals of the TIPS program. According to the member, the original individuals who introduced the program were keenly interested in TIPS as a real-time market estimate of inflation as well as being a way of having the government to monitor its fiscal balances.

Many are talking about China or whoever pressuring the Treasury to up the TIPS issues.  China knows it’s getting zero cents on the dollar in 30 years with anything currently issued by the Treasury–TIPS or no TIPS.  This is really about managing public perceptions about inflation and Uncle Sam’s fiscal responsibility.  We still have an inflationary long term view of the US economy, despite our current short term deflationary view, because eventually, the parabolic monetary base will become parabolic M2.  Inflation is the tipoff, and masking it buys prescious time.  So, with expansion of the TIPS issues, (1) there is the PR benefit that people may believe the government has an interest in keeping inflation low (and monitoring its fiscal balances), (2) it reduces the illiquidity premium that comes from a thin issue base, which will make inflation look lower (to those that are unaware of the illiquidity premium), and (3) having the CPI embedded in a liquid Treasury product gives the understated CPI more authority.  As CPI (both headline and core) is gamed, the Treasury needn’t worry too much about payout–even on the 5′s. 

The member then moved on to the next set of slides which discussed the changing investor base. Using internal estimates derived from experience with the asset class, the member estimated that 60% of the TIPS investor base is dedicated to the asset class while the remainder use TIPS for tactical trading purposes. Of those 60%, a large portion – far greater than nominal Treasury securities – are retail investors. The rest were mainly pension funds, endowments, central banks, and sovereign wealth funds. The member noted that these foreign flows were concentrated in short maturities (5 years and under) to avoid duration risk.

One member noted that pension funds were the source of large outflows from TIPS due to disbursement needs and the illiquidity of the alternative assets in their portfolios. This flow may re-emerge in the future.

The presenting member then turned to the recommended actions. The member stressed more frequent but smaller auctions and a commitment to 5 year issuance as being the most important to supporting the market. In addition, the presenting member suggested replacing 20-year TIPS with 30-year TIPS and increasing TIPS as a percentage of the portfolio. The Committee then discussed the presentation as well as the recommendations.

Why replace the 20 with the 30?  Besides postponing the inevitable payout, there is no 20 year regular Treasury.  However, a 30 Year TIPS can be directly matched with a 30 Year bond to precisely guage inflation expectations, which furthers the inflation perception management hypothesis.

Members remained cautious about the product, citing past discussion of program’s cost, but, given the government financing needs, did not recommend a reduction in issuance. Members did stress that TIPS remain more expensive on a LIBOR basis than the most expensive nominal security.

Another member countered that if the US experienced a period similar to that experienced in Japan in the late 1990′s, TIPS could well prove to be cheap financing for Treasury.

Just like TARP will make the taxpayer a nice return!

One member thought that if central banks were increasing their involvement in TIPS they would be an important future player in the TIPS market.

Regarding changes to how TIPS are auctioned, members voiced no objections to smaller, more frequent auctions if Treasury could overlap them with short nominal coupons. One member suggested Treasury issue shorter duration TIPS. Another member suggested Treasury consider subscription issuance or reverse inquiry as a way of targeting the buy and hold investors which represent a diversification of the investor base.

Several members were concerned that after twelve year of TIPS issuance a liquid inflation swaps market had not developed and no other issuers had emerged. One member remarked that the issue was related to the choice of indexing to headline CPI rather than core CPI. The member said headline CPI was too volatile, too much of a play on commodities for the typical fixed-income investor and left the government effectively playing the commodity market rather than supporting long-term inflation hedging needs.

This will be the eventual excuse when the government says it will retractively fit TIPS to [lower] core CPI as opposed to headline.  Because long term inflation hedging needs are best served by erosion of principal.

The Committee then turned to the recommendation of replacing 20-year TIPS with 30-year TIPS. Several members noted that the 20-year TIPS point was an anachronism of the auction calendar, noting that the 20-year TIPS introduction was at a time when there was no issuance of 30-year bonds. Other members underscored that such a movement would increase the amount of duration for market participants to absorb at auctions and potentially create a security which traded cheaper to the curve. On balance, it was suggested that moving 20-year TIPS to 30-year TIPS seemed like a reasonable course of action.

Additionally, several members found the behavior of TIPS in the second half of 2008 to be disconcerting. Members said TIPS illiquidity left investors with less than the safe government bond they thought they were buying. Another said that perversely investors ran from TIPS during a flight to quality. Another said flights to quality are really flights to liquidity, which TIPS lack. Members agreed that TIPS do not have the liquidity that typically characterizes government bonds.

And they will solve this by upping the issuance.

DAS Rutherford asked the Committee what actions Treasury could take to show its commitment to the program. Several members stated that increased TIPS issuance could be considered, but for financing reasons and not for cost reasons.

The Committee agreed that given debt issuance needs, this was not the time to “cut” issuance, and to remain committed to the program, Treasury could once again publically affirm its commitment as well as move to 30-year TIPS security. It was noted that given the large financing needs which Treasury faced in the coming years, issuing additional TIPS to address those needs in addition to nominal issuance should be considered.

Suggested reading by economist Bob Murphy is here.