After a performance-challenged year in 2013, TIPS delivered strong returns in the first quarter as real interest rates in the U.S. fell in response to modestly weaker economic data. Anyone living in the Eastern half of the U.S. can attest that the data was likely influenced by less-than-perfect weather conditions. Investor focus shifted back to the Fed in the later weeks of the quarter as comments delivered by Chairman Yellen at her inaugural press conference were interpreted to be less dovish than expected. The combination of weaker economic growth and the anticipation of less accommodative monetary policy would be expected to result in a flatter yield curve. Both the nominal and real rate yield curves experienced meaningful flattening during the quarter. While real rates in the front end finished the quarter a few basis points lower, intermediate and longer maturity rates were down 25 to 35 basis points. U.S. TIPS, as measured by the Barclay’s U.S. TIPS index, returned 1.95% for the quarter.
Inflation measures in the U.S., and throughout the developed economies, generally remain below historic norms. In the U.S., the Consumer Price Index (CPI) was up only 1.1% year-over-year through February, while Core CPI, which excludes food and energy prices, rose 1.6%. A much colder-than-normal winter, combined with rising stockpile demand with the approach of the summer driving season, led energy prices higher in the first months of 2014. We expect these higher prices to drive CPI higher in the coming months. Still, with the exception of housing, most components of Core CPI declined during the period. We believe that the persistently weak inflation data continues to reflect slack in the labor market. The U.S. is a service-based economy and as such, much of the costs associated with output are labor related. While we expect economic growth to improve as the year progresses, and we expect slack in the labor market to gradually dissipate amid continued job gains, it remains to be seen how much lower the unemployment rate must fall before wage pressures meaningfully lift the CPI.
In the current period of low inflation, it is natural to question the need for maintaining a dedicated allocation to inflation protection in a portfolio. We recommend staying the course. The cost of purchasing insurance is often less expensive in periods where it is not needed. At 1.75% to 2.25%, breakeven inflation rates in the U.S. are well below the historic average for CPI (2.5%-3.0%), particularly in a period of economic expansion. As stated earlier, economic growth has been strong enough to promote steady job growth which should eventually lead to a tighter labor market and rising wages, the missing component to more normal levels of inflation. Moreover, the resolve of the world’s leading central banks should not be discounted. Central bankers across developed economies are not comfortable with today’s low levels of inflation and are likely to maintain highly accommodative policies until inflation is headed higher. In the U.S. for example, the Fed has set a target of 2% for its preferred inflation measure, the Personal Consumption Expenditures Core Price Index (PCE). This index also excludes food and energy prices. TIPS are indexed to the CPI which does not exclude these factors and has tended to average 50 basis points higher than the PCE. As breakeven inflation rates across much of the yield curve are currently trading below the Fed’s target, we view the current price for inflation protection as good value. When inflation trends back towards the Fed’s target and historic norms, TIPS should significantly outperform nominal U.S. Treasury securities.
Our investment process remains focused on a diversified collection of fundamental, technical, and opportunistic strategies within the inflation-indexed markets. In the first quarter, our fully discretionary client portfolios delivered 15 to 20 basis points above their stated benchmarks. During the quarter, our client portfolios were well positioned to profit from the flatter real yield curve. Typically, we position for a steeper yield curve early in the calendar year as demand for shorter-maturity TIPS expands ahead of the summer driving season. This year, our yield curve slope research pointed to yield curve flattening and we positioned accordingly. Yield curve flattening also benefited the security concentrations we positioned in 10- and 15- year maturities to capture outsized roll down opportunities. Auction cycle trading also proved effective during the quarter. In recent years, primary dealers have allocated less capital to proprietary trading, leading to more pronounced market activity in preparation for Treasury auctions. This has been particularly evident in longer-maturity TIPS auctions. As a result, we frequently position client portfolios for new supply by selling duration in the maturity on offer prior to an auction, and buying the duration back in the auction. If a concession occurs, our client portfolios benefit. In the first quarter, we successfully employed this strategy leading up to February’s $9 billion, 30- year maturity TIPS auction.
Looking forward, we have positioned portfolio durations shorter than their respective benchmarks as real yields continue to trade below our assessment of fair value. The U.S. economy remains on a firm footing, irrespective of its recent challenges with unpleasant weather. As a result, the Federal Reserve is likely to continue tapering its asset purchase program, placing upward pressure on real rates. We have taken profits on our flattening yield curve position as the real yield curve has moved beyond our value assessment in the first quarter. We continue to see value in non-U.S. inflation-linked bonds relative to U.S. TIPS, holding currency-hedged positions in German and U.K. inflation-linked bonds. We expect further convergence between German and U.S. real rates which trade at similar levels despite better growth prospects in the U.S. In the U.K., inflation-linked securities are indexed to the Retail Price Index (RPI), which has run consistently higher than U.S. CPI. We believe that nuances in the composition of the RPI are likely to continue this trend, offering the opportunity for inflation carry in excess of TIPS. In client portfolios that allow for the use of Treasury futures, we maintain a relative overweight to TIPS duration in long maturities. The seasonal impact of the summer driving season on TIPS carry is typically favorable in the first half of the year and breakeven inflation rates often trend higher. In addition, we expect continued improvement in the economy and the labor market to gradually pressure wages and inflation measures higher. Finally, Federal Reserve policy remains focused on driving domestic inflation higher as inflation readings remain below their stated target.
James J. Evans, CFA
Inflation-Indexed Bonds Portfolio Manager
Douglas R. Mark, CFA
Inflation-Indexed Bonds Portfolio Manager / Trader
For informational purposes only.