TIPS Investors Remain Skeptics
Entering the New Year, the trends supporting TIPS looked to be meaningfully improving. Inflation was on the rise and a new administration was proposing policy initiatives which could stimulate still higher inflation. By February, the headline Consumer Price Index (CPI) year-over-year rate rose to 2.7%, a level not seen since early 2012. While the Federal Reserve (Fed) hiked its Fed Funds rate in March as expected, it provided a rather dovish outlook for future rate increases. A more hawkish tone from the Fed would typically be considered detrimental to TIPS as it can dampen inflation expectations. Despite these solid fundamentals, inflation expectations have barely moved this year. So why do TIPS investors remain skeptics? To start, the Administration’s failure to pass the repeal of the Affordable Care Act (ACA) has called into question the prospects for other proposed initiatives. Less discussed but no less important, President Trump will appoint a number of key policymakers to the Fed in the next year (including the Chair and Vice Chair). Conventional wisdom suggests that Janet Yellen’s successor is likely to be a conservative who may very well take a more hawkish monetary policy stance. Finally, energy prices, which are largely responsible for the recent spike in inflation, have been softer in recent months.
While we also view the fundamentals as mixed, we continue to believe that TIPS offer good value relative to nominal government bonds. The recent upward trend in headline CPI has been impressive, particularly considering that the rate was hovering around 0% only two years ago. While the increase in the yearly rate is primarily due to a rebound in energy prices (February 2016 is when crude oil prices fell to their decade-low levels), core inflation has remained steady throughout much of the current economic expansion around 2%. With breakeven inflation rates trading close to 2% across the entire U.S. TIPS curve, investor expectations continue to price in a pessimistic scenario – particularly now that breakeven inflation rates are trading well below both historic norms and actual headline CPI. As a reminder, when actual inflation tracks higher than the breakeven inflation rate priced into TIPS, investors will benefit from positive inflation accruals and often outperform nominal U.S. Treasuries. For much of the 10 years following the inception of the TIPS market, breakeven inflation rates frequently underestimated actual inflation, benefitting TIPS investors. We do not appear to be the only investors who have noticed these attractive valuations. Fund flows into the asset class, as evidenced by mutual fund and exchange-traded funds (ETF) flows, continue to be positive. The TIPS ETF saw an additional 6.5% rise in shares outstanding in the first quarter, following the strong 15% growth experienced in the fourth quarter of 2016.
As widely expected, the Fed raised the Fed Funds target rate range by 25 basis points1 (bps) at its mid-March meeting. While tighter monetary policy is typically not a good thing for TIPS, other details in the Fed’s Summary of Economic Projections (SEP) and their post-meeting policy statement were more supportive of the asset class. The SEP indicated that Fed officials expect a measured pace of rate increases, with only two more rate hikes likely this year. The Federal Open Market Committee (FOMC) statement, which noted the rise in inflation data, also reinforced the “symmetric” nature of the Fed’s inflation goal. This is a reminder from the Fed that its inflation target should not be viewed as a hard ceiling. Instead, inflation can be expected to fall slightly below or above the 2% target at times without raising concern at the Fed. It is noteworthy that the Fed’s preferred inflation measure, the Core Personal Consumption Expenditures Index, is at 1.8% as of February which remains below their 2% target. In our view, the big wildcard impacting Fed policy in the coming years will be how the Trump administration reshapes the Fed Board of Governors. While most expect a slate of conservative nominees, it may be in the Administration’s self-interest to select more dovish leaning policymakers. TIPS investors will certainly be watching these developments closely.
The strong surge in breakeven inflation rates following the presidential election stalled in the first quarter. Breakeven inflation rates across the yield curve hovered around 2% for much of the quarter. While TIPS investors initially perceived a Trump victory as supportive for higher inflation, the policy outlook has since become more uncertain. Protectionist policies leading to higher U.S. wages, infrastructure spending and tax cuts would certainly be expected to create a more fertile environment for inflation; however, policies supporting an increase in domestic oil production are less supportive. More importantly, the inability to garner enough support for the repeal of the ACA has likely left investors with growing doubts regarding the successful implementation of other agenda items.
The eventful news cycle was not reflected in rate markets as volatility was fairly modest throughout the quarter. Real yields across the curve were 5-15 bps lower during the first quarter. The 10-year real yield fell 8 bps, ending the quarter at 0.40%. Breakeven inflation rates were also little changed given little movement in either real or nominal rates. The 10-year breakeven inflation rate increased just one basis point during the quarter to 1.99%. The breakeven inflation curve flattened in the quarter, reflecting strong near-term fundamentals as well as long-term policy uncertainties. The modest change in real yields, combined with positive inflation accruals, resulted in a return of 1.26% for the Bloomberg Barclays U.S. TIPS index. Policy uncertainties aside, breakeven inflation rates near 2% present attractive valuations for long-term investors. Investor inflation expectations remain below current inflation, long-term historical inflation rates, and the Fed’s inflation target for CPI.
With modest changes to real yields and breakeven inflation rates, BBH’s TIPS strategy performed in line with benchmarks. As we began the year, real yields traded below our estimate of fair value leading us to position portfolios underweight duration relative to benchmarks. We closed the duration underweight as political uncertainty expanded during the quarter. Typically, we position portfolios to take advantage of seasonal patterns that suggest a steepening of the real yield curve. While the curve did steepen modestly, the impact of lower energy prices diminished the performance of short-term TIPS, where we were overweight. We continue to believe that low breakeven inflation rates offer good value. We entered the year overweight TIPS in those portfolios where guidelines allow us to do so. Currently, we hold a tactical position in long-maturity nominal Treasuries as recent supply and political uncertainties weigh most heavily on this segment of the TIPS yield curve. Longer term, we continue to favor the attractive valuations in TIPS and will likely redeploy an overweight position to breakeven inflation rates.
James J. Evans, CFA
Douglas R. Mark, CFA
1 A unit that is equal to 1/100th of 1% and is to denote the change in price or yield of a financial instrument