Are TIPS the Right Inflation Hedge in 2022?
U.S. Treasury Inflation Protected Securities (TIPS) have historically been viewed by investors as a way to protect against higher inflation, but what does it mean when these bonds stop acting like an inflation hedge?
Thus far in 2022, we have observed a shift in investor sentiment away from the expected ‘transitory’ inflation and towards fears of stickier and more sustainable inflation on the horizon. With the two main gauges of inflation (CPI and PPI) reporting December inflation levels of 7.0% YoY and 9.7% YoY, respectively, we have reached levels not seen since the early 1980s. The heightened inflation readings have fueled concerns around a more aggressive rate hiking path from the Federal Reserve and validated our larger concern around the management of the bloated balance sheet at The Fed.
Despite these historical inflation levels, we have seen TIPS dramatically underperform other fixed income assets so far this year. In the first three weeks of 2022, the Bloomberg U.S. Treasury Inflation-Linked Bond Index (TIPS Index) lost ~2.20%. This compares to the Bloomberg U.S. Treasury Index which is only down ~1.65%. Additionally, when we adjust for the shorter duration nature of the TIPS Index, the underperformance is even bigger – closer to 120 bps. The longer duration portion of the TIPS market, specifically the on-the-run 30yr TIPS, has seen very dramatic moves lower, down ~9.8% YTD compared to the 30yr on-the-run U.S. Treasury down less than half of that at ~4.8%.
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30yr TIPS vs. 30yr U.S. Treasury
Source: Bloomberg, Smith Capital Investors 1/25/22
The breakeven rate, or the amount of inflation needed for 30yr TIPS to breakeven with nominal Treasuries, has fallen to sub 2.25% despite the recent moves higher in inflation. This metric is down from 2.5% in November even with inflation measures accelerating on all fronts. Meanwhile, real yields on all TIPS remain stubbornly negative by as much as almost 3%.
So what is driving this large scale underperformance of TIPS during an environment when investors expect them to hedge against waves of elevated inflation? The biggest culprit seems to be the fear of The Fed accelerating its balance sheet reduction. The Fed owns a substantial amount of the TIPS market, but its ownership is skewed toward longer duration TIPS. They own a larger proportion of all TIPS with maturities longer than 10 years. In a scenario where The Fed is more aggressive in the reduction of the size and scale of its balance sheet, a natural question arises – who will be the buyer? We have communicated that the market didn’t truly comprehend the power of the agnostic buyer (The Fed) when QE was launched and feel the same today as the agnostic buyer is threatening to become an agnostic seller.
Adding fuel to the fire, last year the two biggest TIPS ETFs both experienced significant asset growth which, in combination with Fed purchases, pushed TIPS valuations to very stretched levels. As the market comes to terms with the fact that The Fed may be a seller, any outflows from these asset classes could further exacerbate the supply/demand disconnect in the TIPS market.
This combination leaves investors in the predicament of what to do with TIPS when they stop acting as a hedge against inflation. There doesn’t appear to be a straightforward answer for this as the pace, scale, and scope of Fed asset runoffs and sales will take many historical relationships and turn them on their head.
While we have not liked the TIPS market due to valuation concerns, there may be some opportunity in the future if the market enters a very oversold position. In a year where we expect heightened volatility, we point to the importance of a process centered in active management that allows for changes in portfolios to better protect investors against nontraditional outcomes, as well as take advantage of opportunities, compared to a static index like allocation. The recalibration process in markets is going to bring new challenges and new opportunities.
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