Many investors took their cue from central bank policies in the third quarter, leading to modestly lower real yields and a flatter curve. Ongoing accommodative monetary policy along with higher inflation data helped drive higher breakeven inflation rates. For quite some time, we have believed that U.S. TIPS valuations have been very attractive to long-term investors. With the firming fundamentals in place and an ever-cautious Federal Reserve (Fed) controlling monetary policy, the U.S. TIPS market looks poised to build on its momentum.
The movement in the yield curve over the quarter reflected changing investor expectations around Fed monetary policy, both near- and long-term. With investors seemingly fixated on every utterance from central bankers, both domestically and abroad, U.S. TIPS 10-year real yields fell a modest 6 basis points (bps) to -0.02%. The real yield curve flattened as real yields in short-maturities increased, while those in long-maturities fell.
Higher short-maturity yields imply that the Fed is closer to its next rate hike than previously anticipated. Several Fed officials have indicated their willingness to hike rates soon and, most notably, Fed Chair Yellen stated that the case for a rate hike had strengthened. Additionally, at their September policy meeting, three members of the Federal Open Market Committee (FOMC) dissented and voted for a higher policy rate.
The decline in long-maturity yields also reflects changing Fed expectations, but in a different way. While the Fed has expressed more hawkish near-term guidance, they have become more dovish over the long-term. The Fed’s Summary of Economic Projections, released after their September policy meeting, showed a lowering of rate expectations over the medium-and long-term. Fed Officials lowered their expectations for the Fed Funds rate target over each of the next several years, as well as their projection of the long-run neutral rate. Furthermore, the aggressive monetary policies from the European Central Bank and Bank of Japan have helped support demand for long-maturity U.S. Treasuries. The European Central Bank is implementing negative interest rate policies and the Bank of Japan is now targeting 0% nominal yields on 10-year government bonds. On a relative yield basis, U.S. 10-year TIPS real yields at 0% compare favorably to real yields in the UK (-2.1%), Germany (-1.15%), and Japan (-0.45%). While foreign exchange hedging costs reduce a portion of this relative attractiveness, the pull of the global government bond market has helped support low yields on long-maturity Treasuries.
Typically, the third quarter is a weak seasonal period for U.S. TIPS. Contrary to this well-established seasonal trend, market-implied inflation increased during the quarter and U.S. TIPS outperformed nominal U.S. Treasuries. The 10-year breakeven inflation rate increased 17 bps to 1.61%. Several positive developments have led us to believe that the U.S. TIPS market could finally be building positive momentum. First, valuations remain quite attractive. The 10-year breakeven inflation rate is well below current and long-term levels of Core Consumer Price Index (CPI), and the Fed’s own inflation target. We have mentioned in recent Quarterly Strategy Updates that the U.S. TIPS market has been implying that the Fed will not succeed in hitting its stated 2% inflation target across any maturity-time frame for which U.S. TIPS exist. We feel that these valuations are very attractive for long-term investors. Second, the reduction in the Fed’s own expectations for its long-term policy implies a continued easy monetary policy stance going forward. Third, flows in the asset class have been positive all year. Despite the typically weak seasonals, U.S. TIPS Exchange Traded Funds (ETFs) saw growth in the third quarter, building upon the asset-growth earlier in the year. The attractive valuations and firmer inflation data have likely contributed to the inflows. Finally, inflation data has moved higher and there is building evidence of a stronger overall inflation picture than shown on the surface.
Overall, the U.S. TIPS market return for the quarter was just under 1%, bringing the year-to-date result to 7.3%. We are pleased to report that BBH’s U.S. TIPS strategy outperformed our respective benchmarks by 5-10 bps in the third quarter and by 20-30 bps year-to-date. We are also pleased that we continue to add value in a steady manner.
We try to take advantage of repeatable market patterns driven by CPI seasonality. In past Strategy Updates we have noted the tendency for U.S. TIPS to exhibit stronger performance in the first half of the year compared the second half. Within the U.S. TIPS curve, we have observed that short-maturity U.S. TIPS tend to outperform in the first half, and lag in the second half. These seasonal patterns exist because U.S. TIPS inflation accruals are based off of the non-seasonally adjusted CPI. The seasonal performance along the U.S. TIPS curve typically leads to a flattening of the real yield curve in the second half of the year.
We positioned for this flattening and benefitted from it during July and August. Although our tendency is to own a position in nominal bonds at the same time, this year we did not because of how low breakeven inflation rates already were. Breakeven inflation rates continue to trade well below current levels of Core CPI and should be well supported. In accounts where we can position by underweighting nominal U.S. Treasuries, we employed a position and benefited as breakeven inflation rates rose modestly.
Inflation data continued on its theme common for the last two years with weak headline measures and stronger core measures. As of the last data release, headline CPI has been pressured by lower energy prices and stood at 1.1% year-over-year. Core CPI, however, has been more robust at 2.3% year-over-year. As the impact of weaker energy rolls out of the trailing data, we expect headline CPI to converge with Core and this is already underway. Headline CPI over the last 3- and 6-months show an increase of 1.5% and 2.2%, respectively (annualized and seasonally-adjusted). We would not be surprised if higher headline CPI readings help generate more demand for U.S. TIPS. We live in a world in which optics matter.
Energy prices aside, other parts of the inflation story look more positive. At 2.3%, Core CPI now matches its highest rate since the Sept 2008. Core CPI continues to be pressured by Shelter costs (3.4%) and the Services side of the inflation picture, such as Medical Care Services (5.1%). Other inflation measures that remove, or minimize the impact of volatile CPI components also point to higher inflation. The Atlanta Fed’s Sticky CPI index consists of prices that do not change frequently. Due to their “sticky” nature it has been argued this could better reflect long-term inflation expectations. The Sticky CPI has been moving upward since 2014 and increased to 2.7% as of August, its highest level since 2009. Another measure, the Cleveland Fed’s Median CPI shows a similar picture, reaching 2.6% in August. The Median CPI looks at all the components in CPI and takes the median price change each month. These other measures tell a much firmer story than the headline CPI data. Despite these indications of firmer inflation data, U.S. TIPS continue to trade at breakeven inflation rates below historical norms and at attractive valuations.
As we head into the fourth quarter, real yields have traded below our estimate of fair value for some time due to aggressive central bank interventions. A change in Fed policy could be a catalyst to move rates closer to fair value. With building dissention in the ranks at the Fed, we have positioned portfolios underweight duration relative to benchmarks. Seasonal patterns typically call for positioning in anticipation of real yield curve flattening and lower breakeven inflation rates, two positions that we have chosen to avoid at this time. Typically, the weaker energy prices in the second half of the year tend to lead to a flattening of the real yield curve. However, recent strength in energy prices has been supported by inventory drawdowns and a discussion from the Organization of the Petroleum Exporting Countries (OPEC) to cap production. Together with an already flat yield curve (driven by global central bank policies), we have instead positioned portfolios to be concentrated in the intermediate part of the curve. In addition, although it typically is a weak seasonal period for U.S. TIPS, we continue to believe U.S. TIPS offer attractive valuations and have positioned those portfolios with the requisite flexibility to be overweight breakeven inflation rates. Inflation is firming right in front of us, yet investors continue to discount what they are seeing. We believe that U.S. TIPS valuations represent an attractive investment opportunity and are poised to outperform through a combination of favorable inflation carry, and at some point, an upward reversion of breakeven inflation rates towards actual levels of inflation. We look forward to continuing momentum.
James J. Evans, CFA
Douglas R. Mark, CFA