When it comes to managing implicit long-term market expectations, the Fed could declare victory now. The 5-year equilibrium inflation rate calculated using Treasury Inflation-Protected Securities (TIP
The recent low in the 5-year 5-year forward balance was around 1.4% at the height of COVID, and the high was 2.4% in early 2022, before the Fed pivoted aggressively to crush inflation and inflation expectations. Recall that during the 2008 financial crisis, TIPS were sold off aggressively as illiquidity and deflation fears surfaced and pushed the breakeven down to around 1.5%. TIPS don’t act like Treasuries should when there’s an exit race.
The Pyrrhic victory over breakeven inflation was costly. In the United States, wealthy asset owners were of course shocked. Those who cannot afford expensive food and gasoline also lose their purchasing power. And those in the middle, who contribute loyally to their retirement plans, find that their nest eggs are worth about 20 to 30% less than at the start of the year. Everyone starts to suffer. Internationally, rising short-term rates in the United States are translating into strong dollar strength, forcing countries like Sri Lanka through what is effectively a revolution. The damage is just beginning to appear, on a global scale.
Although interest rates are mostly raised at the next Fed meeting by at least 75 basis points, the severe inversion of the yield curve, where short-term yields are now higher than almost all Longer maturities suggest the market is pricing in a lot of things, including the global economy, breaking down in the coming months. A real crisis could force the Fed to pivot and go neutral at a minimum and maybe even talk about easing if things get worse. Because those who insist on the fact that the Fed will cure inflation even if it means throwing the economy away do not understand the fact that “monetary policy is the servant of fiscal policy”, to use the words of Paul McCulley. In other words, a political entity that will buckle under the weight of political pressure when Washington complains about a deflating economy. The Fed faces two future constraints: high inflation and cratering markets.
So what’s going to precipitate the pivot I was talking about? Simply an excuse to say that the stability of financial markets has become more of a threat than the economy can bear. As with earthquakes, there are already signs of these precursor phenomena of increased illiquidity. The rapid disappearance of liquidity in many different markets suggests that we are on the brink of financial market catastrophe if more financial stress is exerted on the economy.
The Fed knows it. If they really wanted to slow the economy, there is a way to do it beyond just raising rates. This would include outright asset sales. The trillions in longer-term Treasuries and mortgage transfers they bought during the frantic stimulus to the economy in recent years could be sold off to suck up more long-term cash than just raising rates. . But selling assets into a bottomless pit of illiquidity can also destroy confidence. So I don’t think large-scale asset sales are likely to happen anytime soon.
Back to TIPS.
What is more likely to happen is a compromise. The trade-off might look like this: reported inflation will be FORCED lower. Maybe inflation is stabilizing between 5 and 6%. And because bringing realized inflation down from the recent 9.1% to 2% in a short period can only happen with a deep recession that no one wants, the Fed is slowly starting to telegraph that if 2% is the target long-term inflation, the short-term target is something like 4%. I guess policymakers won’t want to define “long-term” or “short-term” too precisely to retain maximum flexibility.
Let’s assume for discussion that long term means 10 years and short term means 2-3 years. If this is the possible path of inflation, what is the best way for investors to position their portfolios?
A little over a year ago I wrote in this forum why you shouldn’t look for TIPS to protect yourself from inflation (here). But my growing view now is that TIPS, which had already been offered at insane price levels by the Fed and retail ETFs, could begin to offer asymmetric protection and total return potential as well. This is mainly because they have lost a lot of value recently.
TIPS are theoretically an insurance against inflation. But insurance is only effective when the price of that insurance is relatively cheap. When TIPS were trading at deeply negative real yields due to frantic buying by the Fed and retail investors, they were “negative insurance” against inflation. This is why, while inflation has risen sharply, the prices of TIPS and TIPS funds have fallen instead of rising. The pure duration effect of rising real yields, which had inflated the price of TIPS, killed the benefit of the so-called inflation protection. But are we at a stage where TIPS are becoming attractive again?
Let’s take a few examples.
First, just a simple 2 year maturity TIPS. Currently, this TIPS has an actual yield of 0.10%. But the real return earned by an investor is the sum of the real return and the rate of inflation (lots of details about this on the site of the Direct cash). Principal and coupon are adjusted for inflation. So as inflation increases, the principal also increases and the coupon is paid on the increased principal. If we add inflation of 9%, then yes, this bond returns, instantly, in annualized terms, approximately 9.10% (Source: Bloomberg). Good enough. How about a year? If we look at a year and attach probabilities to the various outcomes for actual returns (the way I did this is to use the probability distribution of nominal returns as implied by the market) we can calculate prices of the scenario based on hypothetical yield changes and coupon income. Then we can weight the results with the probabilities of getting the expected return.
If inflation averages 9%, the “expected value” of the annual coupon yield and possible variation in yields is approximately 9.81%. What if inflation averaged 5%? The expected return drops to around 6.5% over the next year. And if inflation miraculously drops to 2%, that bond will still have an expected total return of 3.8%. For an inflation rate of 0%, the total return is about 2%, and you need to have an outright deflation of -2% for this TIPS to have a zero return. There is no magic here, just bond calculations and the incorporation of the total return principles of roll-down, carry and pull-to-par.
Running the same numbers for a 10-year maturity TIPS, we find that at 9% inflation the expected annualized return for a one-year horizon is 10.5%, at 5% inflation in average over the period, the expected total return is 7.1%, at 2% inflation 4.5%, at 0% inflation 2.75% and at -3% inflation (deflation), the expected return is 0 on the horizon. Again, no magic, just bond calculations and an average over implied market probabilities.
So in summary, buying inflation insurance through TIPS was extremely unattractive just a few months ago when the Fed invaded the TIPS market and retail investors followed them like pipers, and dealers ran the Fed and got stuck with TIPS; today, the fact that TIPS have lost so much value due to the unwinding of surplus, as inflation rises, makes them attractive again as fixed income instruments. In effect, the market punished holders of high-priced TIPS by forcing real yields high and prices low. Just when inflation spreads and peaks, voila, the price of insurance becomes cheap again.
If a fumbling and panicked Fed raises rates too quickly and aggressively, I suspect the economy will crash and real yields will fall sharply. TIPS should do well from their current starting point, as they are bonds after all and bonds rally when yields fall. On the other hand, if the Fed stays behind the inflation curve and lets inflation rise, TIPS will offset the higher inflation in terms of higher coupon and principal. That’s why they are called TIPS after all.