Over the past two months, rising rate momentum in the United States has triggered a global shortage of US dollar liquidity. Most international exchange rates fell to extreme historic lows, prompting a rally from other global central banks against the Federal Reserve. warmongering approach. Two weeks ago, the trend became so severe that the The British pound had a big flash crash, forcing the Bank of England to pursue a temporary purchase of long-term bonds program. A few days ago, the shortage of dollars also caused the Federal Reserve to send more than 3 billion dollars at the Swiss National Bank via a short-term liquidity swap to cover its potential lack of dollar liquidity. The Bank of Korea has also recently agreed to open a swap linewhile there is speculation India’s RBI may be researching follow suit in a context of significant deterioration of the currency.
Virtually all major exchange rates have suffered record lows this year. Interestingly, the only exception is a few Latin American currencies, such as the Brazilian real and the Mexican peso. See below:
Major currencies, such as the euro, yen and pound, are resting at their lowest levels in decades. At such an extreme, we can expect the common “mean reversal” nature of the forex market to kick in and drive the US Dollar lower. However, this outcome would likely require the Federal Reserve to become much more dovish or its peers to become more hawkish. The latter is possible, but given the higher than expected trend in inflation data, I in general doubts that the Federal Reserve will soon become less aggressive. Even then, the US dollar shortage crisis may have grown large enough to spiral almost out of control as many emerging market currencies plummet. This situation has occurred for the Turkish lira and many “softly pegged” African currencies, many of which have significant debt denominated in US dollars, which has exacerbated their exposure to the strong dollar.
The global shortage of US dollars has reached crisis levels and is, in my view, the most critical factor in financial markets today. Surprisingly, it hasn’t received much attention from most of the financial media despite many major global central banks and commercial banks rushing to cover dollar shortfalls. I covered the potential for a massive US dollar squeeze earlier this year, and it looks like we are now seeing those events play out in full. Although I’ve been generally bullish on inflation-linked Treasuries, I noted that they could continue to fall if the Federal Reserve remained hawkish despite the economic trend toward recession. Real interest rates and the value of the U.S. dollar are closely tied to the fact that the United States is now one of the few countries with a positive yield on inflation-linked bonds, leading to immense demand US dollars.
I think we could soon see the US dollar climb even higher as the international currency squeeze reaches its final wave. However, with this in mind, it seems unlikely that the Federal Reserve will become more hawkish than it already is. Inflation-linked bond funds such as NYSEARC: ADVISORY still carry some downside risk due to their trend. Yet, in my view, they have become a desirable low-risk investment due to their positive inflation exposure, high real yield, and potential for appreciation in a currency-scarce environment.
US real interest rates are near highs
The iShares TIPS Bond ETF (TIP) invests in longer-term, inflation-linked Treasury bonds. These bonds pay for the change in the CPI over a given year, currently around 8-9%, more a yield of around 1.7% – giving a near double-digit yield on “risk-free” US sovereign debt. Since TIP holds US Treasury bonds, it is also exempt from state and local taxes. The main risk of the TIP is its “duration”, which is the extent to which its value decreases (or increases) based on a change in long-term interest rates. Its current duration is around 6.8%, which means that it will decrease by 6.8% if real rates increase by 1% (and vice versa). As long-term rates have risen rapidly this year, the price of TIP has come under pressure.
As you can see below, five- and ten-year inflation-linked treasury bill yields are the highest in over a decade:
TIP has a weighted average maturity of around seven years, so its yield falls between five and ten-year rates. A rate of 1.7% means that the TIP pays 1.7% more regardless of the increase in the CPI. This yield differs from a typical treasury bill which yields around 4% today but is not indexed to inflation, which means that its actual yield is generally much lower than that of the TIP given the rate of current inflation of 8 to 9%.
Technically, since inflation-linked treasury bills and “traditional” treasury bills have the same underlying credit risk, the difference in their yields is an indicator of expected long-term inflation (because both should have the same “expected” net return). This “equilibrium rate” indicates long-term average inflation – currently around 2.3%. Given that the PPI and CPI figures have consistently exceeded expected levels despite the Federal Reserve’s hawkish policy, I doubt that inflation will average 2.3% over the next five years, as implies the break-even rate over five years. If this turns out to be correct, the TIP will offer a very high “excess” yield over traditional Treasuries, which seems to misjudge inflation risk. The bond inflation expectation rate is closely tied to the price of crude oil as it is the most crucial inflation factor (due to the compound nature of transportation costs in commodity prices). See below:
The supply of crude oil, and most energy commodities, are among the few factors entirely beyond the Federal Reserve’s control. For many reasons, I firmly believe that the supply of crude oil will become more constrained in the months (and years) to come. Barring a drastic and seemingly unlikely decline in economic activity, I believe energy prices in the United States will continue to rise. This factor is even more important in Europe, which suffered another pipeline closure, potentially exacerbating rising inflation on the continent and associated currency weakness. Since Europe and the United States share trade and financial networks, higher inflation there will likely mean higher inflation here.
If inflation continues to be higher than expected, the TIP will outperform traditional sovereign bonds, potentially significantly, given the high level of inflation. If the CPI continues to rise at an 8-9% rate, TIP’s total dividend yield would be around 10-11%. Typically, these yields are only found in very high-risk emerging market sovereign bonds or very low-quality commercial debt. Additionally, I expect inflation-indexed rates (or “real rates”) to stop rising soon as they reach about 12-year highs. More importantly, the currency crisis could become more extreme if US real rates continue to rise. Given the slowing US economy, it is also possible that the Federal Reserve will slow down or stop the shedding of inflation-linked bonds (end of QT, but no restart of QE), potentially improving their value.
Main risks associated with inflation-linked bonds
I’ve had a bullish view of the TIP for the past six months, and the fund has fallen a bit despite that, as real interest rates have risen despite the slowing economy. Inflation-indexed rates are still about 50 basis points below their high range of the 2000s; if they rise much higher, the TIP will decrease by 3-4%, given its duration. To me, this is minimal downside risk relative to its upside potential, especially given the growing forces in the currency market that could trigger a reversal in real interest rates.
Of course, as we saw very briefly in 2008 and 2020, a decline in market liquidity can cause inflation-linked rates to rise extremely quickly. In both cases, the Federal Reserve provided liquidity to end an even deeper liquidity crunch. Given the high inflation, it is not necessarily guaranteed that the Federal Reserve will start again. In reality, I highly doubt that we will ever see QE again due to the associated hyperinflation risks. That said, as we see in the UK sovereign bond market, the Federal Reserve will likely be willing to act as a short-term liquidity provider to stop a flash crash.
Moreover, if real interest rates (and “traditional” bond rates) were to rise rapidly by more than 100 basis points (i.e. if the Federal Reserve does not step in to provide liquidity), then the U.S. government would likely be quickly forced into default. The default is hypothetically possible because the federal debt is so large that a slight increase in rates would cause the entire budget to be allocated to interest expenditure. Hypothetically, TIP and all Treasury debt has no risk of default, given the monetary authority of the Fed. Nevertheless, if it is a decision between hyperinflation and partial default, the latter can be chosen. In my opinion, this is a very difficult risk to quantify, but given the extreme dynamics of the international currency markets, it is a risk to consider.
In all likelihood, the Federal Reserve will not become so hawkish that it refuses to provide liquidity during a liquidity crisis. Given the developing dollar crisis overseas, I think this could happen over the next few weeks or months and would likely be a bullish catalyst for the TIP. In other words, I’m bullish on the TIP as Federal Reserve support will become necessary. if it continues to fall (which causes the dollar to rise).
Given that I expect inflation to remain high and potentially on the upside if OPEC+ continues to cut oil production, TIP’s yield could be much higher than other Treasuries for a period. prolonged. With fewer assets having a “Fed put” today than in 2020, inflation-linked bonds appear to be protected. Additionally, TIP offers investors a tax-efficient return of 1.7% above inflation. In my view, these catalysts make TIP a solid, low-risk, long-term investment with decent potential for higher short-term reversal.