An Introduction to Treasury Auctions

It remains to be seen whether the growing U.S. Department of the Treasury auctions will be a relatively quiet sideshow or eventually take the center stage in the ongoing financial crisis. As the number of potential disaster scenarios continues to shrink, one subject that I see receive surprisingly little play in the blogosphere is one of the few remaining potential disasters: the auction of U.S. debt.

The concern is that as the U.S. debt grows, so does the volume of Treasury debt for each auction. The big fear is that at some point the supply of U.S. debt may begin to outstrip the demand. At the moment, China and Japan account for about 2/3 of all foreign holdings of U.S. Treasuries; any plateau in the demand for U.S. debt from these two nations might necessitate higher interest rates to stimulate demand and could send potentially traumatic shock waves throughout the economy. This is the disaster scenario. So far, I am happy to report, demand for Treasuries has been robust and yields have remained at very low levels.

The U.S. Treasury auctions a mixture of Treasury Bills (with maturities from 4 weeks to 52 weeks), Treasury Notes (from 2 to 10 years) and 30-Year Treasury Bonds. The T-Bills are auctioned on what is largely a weekly cycle, with the typical pattern seeing the 13-week and 26-week T-Bills slotted for Mondays and the 4-week and 52-week T-Bills on Tuesdays. Given the frequency of these T-Bill auctions and the relatively low demand from foreign central banks, the T-Bill auctions are probably the least important auctions in terms of being able to gauge market sentiment and the strength of foreign demand.

The more important auctions are of the Treasury Notes, where the 10-Year Note has become the de-facto benchmark for U.S. long-term debt. Treasury Note auctions are best understood as occurring on a monthly cycle, with the 3-Year and 10-Year Notes typically auctioned on Tuesdays and Wednesdays during the second week of each month and the 2-Year, 5-Year and 7-Year Notes typically auctioned off on Tuesdays, Wednesdays and Thursdays of the last week of each month.

The 30-Year Bond and Treasury Inflation Protected Securities (TIPS) are a much smaller part of the Treasury refunding process and are subjects for another post.

The results of Treasury auctions are announced at 1:00 p.m. ET (see Announcement & Results Press Releases) and contain three particularly important pieces of information:

1. Yield
2. Bid-to-cover ratio
3. Percentage of indirect bidders

In short, the yield determines the cost of the debt refunding and/or the price sensitivity of the bidders. The bid-to-cover ratio is simply the total dollar amount of the bids tendered by the total amount of the securities being auction and reflects demand relative to supply. Finally, the percentage of indirect bidders is used as a proxy for demand from foreign central banks, as indirect bids are bids of significant size that do not go through the primary dealer community.

Going forward, investors should keep an eye on the Treasury auctions, particularly on the demand for U.S. Treasury Notes. Should yields start rising, bid-to-cover ratios start falling and participation by indirect bidders begin to decline, then we may have the beginnings of a new kind of debt crisis on our hands.

For additional information on Treasury auctions, try:

• Tentative Auction Schedule of U.S. Treasury Securities
• Recent Results for Notes, Bonds and TIPS Auctions
• Today’s Auction Results
• Recent Results for Bill Auctions
• Announcements & Results Press Releases
• Major Foreign Holders of Treasury Securities
• Who Buys Treasury Securities at Auction?

For some VIX and More posts on TIPS, readers may wish to check out:

• Treasury Inflation-Protected Securities and Inflation Expectations
• Chart of the Week: TIPS Breaking Out

Chart of the Week: TIPS Breaking Out

While there were many important stories that broke this week, the one which found me briefly holding my breath was the failed auction of £1.75 billion in U.K. government 40-year bonds on Wednesday followed by the weak demand for $34 billion of 5-year U.S. Treasury notes later in the day. While Thursday’s successful auction of $24 billion of 7-year U.S. Treasury notes has temporarily put the government debt auction issue on the back burner, the interest rate plot is clearly thickening – and the debate on deflation vs. inflation is starting to heat up.

One excellent way to protect against inflation is through the use of Treasury Inflation-Protected Securities, more commonly known as TIPS. As I noted last September in Treasury Inflation -Protected Securities and Inflationary Expectations, TIPS utilize the CPI as an inflationary benchmark and TIPS coupon payments and the underlying principal are automatically adjusted to account for inflation.

All of this brings us to the chart of the week below, which shows a ratio of the iShares Barclays TIPS Bond Fund ETF (TIP) to the 10-Year U.S. Treasury Note. This ratio has seen several jolts in the last six or so months, but since mid-December, investors have shown a strong preference for TIPS over the standard Treasuries. In fact, as concern about inflation has elevated during the course of the last week or so, TIP, with an average maturity of approximately nine years, has moved up impressively while Treasuries with comparable maturities have fallen. The ratio is now approaching its pre-Lehman levels, so that further moves could help to gauge whether inflationary or deflationary fears are dominating the thinking of investors.

[source: StockCharts]

Treasury Inflation-Protected Securities and Inflation Expectations

First there was the inflation scare, then there was the deflation scare, and now it seems any network or blog can find enough economists to support either scenario as a grave concern for the economy.

In times of confusion, I like to take my cues from the markets. This time around I am talking about the future inflation rate expectations that can be derived from Treasury Inflation-Protected Securities, more commonly known as TIPS. Using the CPI as an inflationary benchmark, TIPS coupon payments and the underlying principal are automatically adjusted to account for inflation. With a couple of assumptions to mitigate a liquidity premium and inflation-risk premium, a market assessment of inflationary expectations can be derived from the difference in yield between nominal treasury notes and TIPS, which is exactly what the graph below shows.

Based on the TIPS yield differential analysis, it appears as if inflationary expectations peaked in either late February or late June and have been steadily trending lower over the course of the past two months, to the point that current inflationary expectations are at levels not seen in at least ten months.

[source: Federal Reserve Bank of Cleveland]