2018_11_08 — “Watching TIPs [and Carpet] Grow”
November 8, 2018
Watching TIPs [and Carpet] Grow
Since shortly after the great financial recession of 2008/09, when the Fed started quantitative easing and loosened its monetary policy, many investors have expected strong and rising inflation. Those investors have mostly been disappointed. After years of going nowhere, Treasury Inflation Protected Securities (TIPS) yields have only in the last year or two finally risen. But those that expect this trend to continue will probably be disappointed.
Inflation signs are weak, demographics and technological productivity are working against inflation, and most importantly for TIPS, the Fed continues to raise short term rates. Historically, if there’s anything that snuffs out inflation quickly, it is rising short term rates.
Since September 2017, 10-year TIP yields have risen approximately 80 basis points while 10-year Treasuries have risen about 110 basis points; thus inflation compensation has increased by a mere 30 basis points. So much for the great run up in inflation that headlines have attempted to shout.
In addition, don’t expect the trend in inflation compensation to continue. Inflation, as compensated by TIPS, may not have the chance to increase much further. The market expects the Fed to raise short-term rates five or six more times through 2020, which will certainly temper most chances of inflation in a decelerating U.S. economy. Even my more dovish estimate of three more rate raises through the middle of 2019 will be negative for TIPS because in such a case, the Fed will broadcast that growth (and inflation) has weakened to the point that it doesn’t need additional monetary temperance. Keep in mind that the real yield of 10-year TIPS primarily reflects expectations for the real federal funds rate over the next decade. Thus, although diversification is usually vaunted, most portfolios will probably be well served by continuing to avoid TIPs and deploying their allocations to more productive sectors.
Except for some esoteric fixed income portfolios, TIPs have not done much for investment performance over the last decade, and their near term outlook looks equally dull. Of course, what would really catch markets off guard is if a dovish Fed combined with decelerating U.S. growth causes 10-year Treasury yields to decline back towards 2.5%. Understanding the possibilities of these dynamics and how to optimally structure portfolios is where professional advisors can shine.
Michael Ashley Schulman, CFA
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Disclosure: The opinions expressed are those of Michael Ashley Schulman, CFA and are subject to change without notice. The opinions referenced are as of the date of publication, may be modified due to changes in the market or economic conditions, and may not necessarily come to pass. Forward-looking statements cannot be guaranteed; neither can backward-looking nor current-looking statements. This material is provided for informational purposes only and does not constitute an offer or solicitation to purchase or sell any security or commodity or invest in any specific strategy. It is not intended as investment advice and does not take into account each investor’s unique circumstances. Information has been obtained from sources believed to be reliable, but its accuracy, completeness and interpretation cannot be guaranteed. Past performance is no guarantee of future results.
