Treasury Prediction Markets

Disclaimer: This essay is a work in progress

Exigence

The past couple years have brought on renewed debates over Federal Reserve policy as the economy dangles between recession and inflation. The July unemployment report in particular has raised concerns over the refusal to lower rates in the July FOMC meeting.

Despite unemployment edging up to 4.3%, GDP growth in Q2 and GDPNow forecasts for Q3 remain strong while NGDP continues to grow above trend running the risk of continued excess inflation despite the 5 year implied inflation rate by TIPS finally dropping below 2%.

Although market forecasts of inflation remain useful, they do not give enough actionable information on what the Fed should do to remain consistent with the dual mandate leading to excess debate from people who would otherwise defer to the efficient market hypothesis.

Fixing Treasury Inflation Protected Securities

Current TIPS do not fully reflect expectations of inflation. In the short term, the lower liquidity of the asset leads to increase yields as compensation, understating inflation. In the long term however, the inflation hedge lowers yields as it reduces interest rate risk for the holder, overstating inflation.

TIPS work through an auction system where institutions cast bids at particular interest rates. Every 6 months, interest is applied to the principal and the principal gets adjusted upwards and downwards as CPI-U moves upwards and downwards. They are sold with 5, 10 and 30 year maturities.

The Treasury should begin selling anti-TIPS, TIES(Treasury Inflation Exposed Securities) which calculate whatever dollar premium would go to the equivalent TIPS and subtracts it. TIES will increase interest rate risk for the holder increasing the coupon rate over the long term and thus they will err towards higher inflation, similar to TIPS. However, in the short term their illiquidity will affect the coupon rate in the same direction, and thus the two biases can cancel each other out if you compare market yield between TIPS and TIES rather than TIPS and regular treasuries.

As TIPS and TIES have opposite reactions to inflation, owning one of each is equivalent to owning 2 treasuries of the same maturity. As such, the Treasury should allow free conversion between the two types of assets similar to how Authorized Participants can interact with ETFs.

These changes will increase liquidity, allow for more accurate short term predictions of inflation and allow for easier bets on inflation going down without the need to short TIPS or TIPS ETFs which carry a cost.