Treasury Inflation-Protected Securities, or TIPS, had already been doing well in the New Year after returning almost 14% in 2011, according to the Barclays Capital U.S. TIPs Index. The asset class got a further boost last week after the Federal Reserve not only extended the period of time it is likely to maintain an unusually easy monetary policy stance, but also moved toward adopting a formal medium-term inflation target of 2% for the PCE (Personal Consumption Expenditure) Index.
The result: 10-year real rates (as measured by the January 2022 TIPS) rallied 15 basis points to -0.20%, and 10-year inflation expectations widened 10 basis points to 2.15% in just a few hours of trading after the Fed’s announcement on January 25. We believe this reaction is mostly logical and still think it makes sense to have an allocation to TIPS in this environment despite the low real yields they currently offer.
A deeper dive into the central bank’s latest announcements and their implications for the asset class is in order.
The Fed changed its commitment to accommodative policy rates from the middle of 2013 to late 2014. This means we are likely to have negative short term real interest rates for much longer than previously expected – provided inflation stays positive over this period. As expected, shorter term (five year) TIPS led the fixed income rally. Thirty year real rates also rallied significantly, outperforming comparable nominal Treasuries. This reaction was rational, because a dovish Fed portends lower real interest rates and higher inflation expectations across maturities.
The more unexpected move was the Fed’s adoption of a formal medium term inflation target of 2% for the PCE index. In his question and answer session Fed Chairman Ben Bernanke said that, given the central bank’s dual mandate of price stability and job creation, the central bank was likely to allow deviations from this target if employment was not where the Fed thinks it should be. Given the current high unemployment rate, the market interpreted this to mean that the Fed would tolerate above target inflation for the time being. This of course increases the attractiveness of TIPS relative to nominal Treasuries, and the market reacted accordingly.
There are a few subtleties regarding the inflation target worth noting.
Among them: The Fed has adopted an explicit target of 2% for the PCE index. This is at the top end of the long standing implicit target of 1.7%-2%. This “increase” in the inflation target should boost inflation expectations. Moreover, the PCE index tends to run ¼% - ½% below the Consumer Price Index (CPI) due to a different calculation methodology as well as slightly different weights for the consumption basket. We expect this difference to persist going forward.
So we now have an “explicit” target for CPI inflation, to which TIPS are indexed at 2.25%-2.5%. Since the implied inflation rate for TIPS across maturities was essentially at or below this range before the Fed meeting, a natural response would be to increase inflation expectations till they fell in this range – leading to TIPS outperformance.
Finally, to the extent that the Fed is credible, an explicit inflation target should reduce the volatility of inflation, and hence the inflation risk premium priced into the long end of curves. This effect should lead to a flattening of nominal curves. We have not seen this, as the nominal (and real) curves have steepened subsequent to the Fed’s action. This could be either due to the fact that the other factors mentioned above have dominated this effect, or because the market views this new, slightly higher, inflation target as the first in a number of steps to ease monetary policy in an attempt to reflate the economy.
So where does that leave us regarding the attractiveness or lack thereof in TIPS?
What are TIPS?
TIPS, or Treasury Inflation-Protected Securities, are bonds issued by the U.S. Treasury. They have the unique property that their principal, or face value, moves one-for-one with inflation as manifested in the Consumer Price Index (not seasonally adjusted), while their interest rate remains fixed (though interest payments rise if principal rises or falls if principal decreases). Of course, the current market value of TIPS or the value of a portfolio that invests in them may fluctuate. TIPS are used by both individual and institutional investors to hedge against potential future inflation, and the real return is known, if held to maturity, (though the dollar payments may change) since the payments are linked to inflation. Real return refers to the return after adjusting for inflation.
We agree that government bond rates are lower than they should be and are artificially repressed by the Fed. Given that, PIMCO believes the unique characteristic of TIPS payments being linked to inflation warrants considering an allocation even at these current low real yields.
First, we think financial repression is likely to persist, so real interest rates are unlikely to rise in the near term, and moreover are likely to be lower than recent history would suggest for the foreseeable future. Second, with TIPS you know what real return you are getting, if you hold to maturity. Comparing yields in a hypothetical example, if inflation for the next 10 years averages 3% and the nominal 10-year Treasury yield is 2%, then the real return on nominal 10-year Treasuries could end up being -1%, significantly lower than that offered by comparable maturity TIPS – recently yielding -0.20% as mentioned above. Given all the unconventional policy measures at work in the markets, we believe it is advisable to invest in something with a known hedge to inflation. Finally, negative after inflation returns on cash for an indefinitely extended period of time is not attractive. TIPS investors should utilize the additional return potential offered by longer maturities due to the steepness of the yield curve to seek positive real returns while hedging against the possibility of higher than expected inflation.
The TIPS market reaction to the Fed action was logical. We feel that the real return potential offered by the asset class, coupled with the fact that interest rates seem unlikely to rise anytime soon, warrant considering an allocation even at current valuations.