July 12, 2022
The consumer price index (CPI) is scheduled to be released on Wednesday and it is widely expected that the headline inflation number will again resemble consumer price increases last seen in the early ‘80s. Currently, consensus expectations are for headline inflation numbers, which include food and energy prices, to increase by 8.8% year-over-year (YoY) and by 5.7% YoY excluding food and energy. So with inflation pressures continuing to run hotter than many investors have experienced in quite some time, are Treasury Inflation-Protected Securities (TIPS) an appropriate inflation hedge within a diversified asset allocation?
Certainly from a valuation perspective, the argument for owning TIPS has improved. As seen on the chart below, after spending years in negative territory, TIPS yields are decidedly positive again for 5-year, 10-year and 30-year maturities. Moreover, since 2013, TIPS yields have rarely been higher. For the three tenors presented below, yields are currently in the top quartile, meaning only around 25% of the time have yields been higher than they are currently. “Paradoxically, despite higher realized inflationary pressures, TIPS yields have actually increased (and prices lower),” noted LPL Financial Fixed Income Strategist Lawrence Gillum. “That may be because markets are pricing in a return to a more normal inflationary environment after these near term price pressures abate.”
Additionally, one of the key metrics we look at as a guide to determine if/when it makes sense to own TIPS versus just owning comparable maturity nominal Treasuries is the “breakeven” rates between the two securities. That is, the difference in yields between the two securities, which is also the market’s best guess about what inflation will average over the maturity of those securities. All things equal, when the breakeven rate narrows, performance between two comparable maturity securities is expected to be similar absent inflation surprises. As seen in the LPL Chart of the Day, market-implied inflation expectations seemingly peaked in March and have fallen closer to longer-term historical averages. So, if central bankers are correct and we are on the precipice of a new structurally higher inflation regime, it’s possible that we could get periodic upside inflation surprises, which may allow TIPS to outperform Treasury securities. As such, depending on your views on inflation on a go forward basis, it may make sense to allocate a small portion of your bond portfolio to TIPS.
However, while valuations have improved for TIPS, the aggressive tightening expected from the Fed to arrest consumer price increases, potentially at the expense of economic growth, may cause real yields to increase and inflation expectations to fall further, in our view. Further, during periods of economic slowdowns, despite being a government-issued security, TIPS have not, historically anyway, provided the same level of equity market protection as nominal Treasuries. Finally, since 2013 and up until the COVID-19 pandemic, TIPS have generally underperformed Treasury securities as inflation was well contained and rarely surprised to the upside, at least consistently. So, if we’re not headed for a new higher inflation regime, TIPS may continue to underperform. Certainly the value proposition for TIPS has improved but given the expected reaction function of the Fed, we think TIPS could underperform nominal Treasuries in the near term.
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