Anchors 'away'

(MarketWatch) -- As the Federal Open Market Committee gathers this week to discuss monetary policy and the economy, it will have to include in its discussions an exit strategy for draining some of the gobs of liquidity it has pumped into the economy, since inflation expectations can no longer be said to be "well anchored."
I say this because of several recent developments.

Last week, the government's sale of new five-year Treasury Inflation Protected Securities (TIPS) was a smashing success. The yield on these notes fell to 1.278%, much lower than the 1.375% rate on their when-issued counterpart just before the auction.

The auction also produced an unusually high bid-to-cover ratio of 2.66, indicating extremely strong demand for a security that yields much less than its plain vanilla counterpart.

At the turn of the year, the spread between the 10-year version of these two instruments was zero. The markets were more focused on the falling economy and the threat of deflation than anything else, so they bought the regular Treasury in such large quantities that its yield fell to the same level as the TIPS.

But the jump in the spread between the 10-year Treasury note yield and the yield on the 10-year TIPS since then is indicative of the markets' growing preference for a government security that provides inflation protection as well as some yield.
By favoring the TIPS over the regular note, the markets have pushed up its price, thus depressing its yield far below that of its non-indexed counterpart.

This sudden shift in the markets' thinking reflects a feeling that the fourth quarter represented the worst of the recession, and that things have begun to moderate since then.

It began to percolate slowly through the fixed-income markets early in the year and now appears to be the view of most economists.

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