As the specter of Fed-tightening haunts markets, TIPS and Treasuries alike have come into the spotlight. Yields on both have skyrocketed and their prices plunged. Emerging from the spread between the two, however, is a bet that markets are underpricing future inflation and future expectations of it that seems very attractive. Exotic though inflation-based trades may seem, a new ETF (RINF) has made this exposure available to the retail investor.
As an alpha-generating tactical trade, the proposed trade of going long break-even inflation (BEI) is a good idea. But the position also likely has substantial diversification benefits for your portfolio. So it will help you improve your Sharpe ratio on top and on bottom, by increasing returns while reducing overall portfolio volatility.
The Current Market Pricing of Future Inflation
What level of inflation is the market pricing right now? You can back this information out of the difference between the Treasury yield curve and the TIPS yield curve. The yield spread between the TIPS yield and the Treasury represents "break-even inflation," or the compensation that holders of nominal Treasuries demand due to the risk of inflation.
Stripping out the various parts of the real yield curve from one another, you can deduce the priced in expectations of inflation between different points in the future time. You can reliably extract this information because a 5-year TIPS is effectively "embedded" into the 10-year TIPS, and the 10-year TIPS into the 30-year TIPS. As a result of this relationship, doing some simple math, you can calculate the market expectation of inflation over specific intervals of future time (this is the case with all government bonds). The yield difference between the 5-year and 10-year TIPS tells you what the market expects the real yield to be five years from now, if you do the math.
These are the annual rates of inflation implied by the differences between the yields of TIPS and Treasuries of different maturities.
Expected Future BEI (Per Annum)
2013 through 2018
2018 through 2023
2023 through 2043
The point is that future inflation seems likely to exceed what this TIPS-Treasuries spread is currently pricing in. Should market participants come to expect future rates of inflation to be higher, or should you hold the security as inflation comes in higher than priced in, this trade will make money. And it seems likely that the market is in fact underpricing future inflation.
The Bullish Case From History
From a long-term historical perspective, a bet on break-even inflation increasing seems attractive. As the chart below demonstrates, inflation over the past hundred years in the United States has averaged 3.22%. Inflation may be volatile over any single interval of time. But, like anything else, due to the law of large numbers, inflation is more predictable over longer periods of time (like 30 years).
click to enlarge images
Inflation may have been conspicuously low for the past few years. But it seems all but inevitable that at some point over the next 30 years, the US economy will be in a very different place in the business and debt cycle. This suggests that inflation is more likely to and that approximate its higher historical average rather than the low levels of the recent past. In fact, if inflation rates are fairly stable over long periods of time, the unusually low sub-2% rates of the past few years suggest that future rates of inflation will be higher than the long-run average of 3.2%.
The recent rates of inflation are as exceptional as the 2008 credit crisis, a major source of deflationary pressure. Market participants tend to rely too much on their own experiences and price the future like the past. And history suggests they are currently underpricing inflation.
The Bullish Case From Today
But this is not merely an argument based on the assumption that one century's history is another's roadmap. Economic conditions today suggest that inflation is likely to uptick in the future.
It is not difficult to understand that wages are a major source of inflation. A rise in the cost of labor is a rise in a cost paid by every business, businesses need to be profitable, and so businesses raise prices. And the outlook for the labor market seems to be one of rising demand and falling supply, a scenario likely to create wage-driven inflation.
On the demand-side, employment figures in the United States continue to surprise to the upside. Manufacturing jobs seem to be returning to the United States (discussed more below). And in spite of its recent talk of future tightening, the Federal Reserve does seem committed to maintaining policies consistent with a reduction in unemployment. Today's Fed is a Fed that privileges employment rather than low inflation, so the drops in unemployment metrics seem unlikely to abate in the future. The Fed would sooner see inflation expectations rise than employment stumble.
On the supply-side of the labor market, demographic trends seem as if they are making a decline all but inevitable. The percentage of Americans working or looking for work is at its lowest level since 1979. While a certain fraction of those leaving the workforce are the long-term and disillusioned unemployed, a major cause of this trend is the aging of the US population and the "baby boomers." So both the supply and demand ends of the labor equation both suggest that wages, a major source of inflation, are likely to rise in the future.
As industrial capacity becomes scarce, demand for goods exceeds their supply, and prices rise. As the chart below demonstrates, rates of capacity utilization tends to lead rates of inflation. And rates of capacity utilization today seem likely to increase.
According to the Federal Reserve's June report, the utilization of existing capacity is now 2.6% below its long-run average (1972-2012). Again assuming long-term averages are stable, this suggests that capacity utilization is likely to increase. But more causally direct factors, like the recent spike in interest rates and the specter of Fed tightening, seem likely to result in substantial increases in capacity utilization in the near future.
The current low levels of capacity utilization are intimately related to the low interest rates the Fed has maintained for the past few years. Indeed, the point of Operation Twist was to lower interest rates on debt of the longer maturities that tend to finance capital investments and increase industrial capacity. According to the Fed, the stock of industrial capacity grew by 1.9% between May 2012 and May 2013. But that supply growth occurred in the context of a low interest rate environment that seems to be fading, if not already gone.
While the rate of increase in the supply of capital seems likely to decrease, demand for American industrial capacity is increasing and likely to continue to increase. While the supply of capacity increased 1.9% over the past year, the utilization of that capacity fell by .2% over the same time period. This implies that demand for capacity increased by roughly 1.7% over the same period. This rate of demand makes the rate of overall capacity utilization vulnerable to a decrease in the rate of its supply.
And broad macroeconomic trends suggest that demand for American industrial capacity will likely only continue to increase. The combination of higher oil prices and persistent high inflation in China seems likely to be behind the recent resurgence of US manufacturing. Higher prices in China and higher oil (i.e. higher transport costs) both make outsourcing manufacturing to China less attractive for American producers, who have to pay prices in China and transport their goods. These pressures seem likely to account for at least part of the recent resurgence in US manufacturing, and Chinese inflation shows few signs of abetting, even if oil fluctuates. And an increase in manufacturing in America would clearly increase the utilization of American industrial capacity. So the reliable leading indicator of inflation that is capacity utilization seems likely to increase as the rate of American capacity creation falls while demand for American industrial capacity rises.
Risk Parity, Market Dislocations, and Your Buying Opportunity
The recent spike in real yields has punished "risk parity" funds who typically deploy leverage to gain exposure to TIPS. Risk parity managers deploy leverage because they want inflation-related risk to account for a large portion of their returns. $100 in TIPS is much less volatile than $100 in equities, so leveraging TIPS is necessary for the "risks to have parity." The recent spike in real yields has punished these managers: Bridgewater's $70 billion All Weather risk parity fund lost 6% in the month of June alone. If real yields continue to rise, as they seem likely to, risk parity managers seem likely to face large amounts of redemptions by spooked clients.
While they are significant players in the market, risk parity managers are likely to have to sell only tens of billions of dollars worth of TIPS, which are now a nearly $1 trillion dollar market. Their forced liquidation of TIPS now, at the start of the rise in yields, would therefore present a buying opportunity and a departure from their fair value rather than a fundamental downward pressure for TIPS going forward.
For clarity's sake, it seems prudent to distinguish between going long break-even inflation and going long TIPS. Risk parity managers buying TIPS are sensitive to real yield increases arising from an increase in the nominal yield, since the real yield is the difference between the nominal yield and inflation expectations. By shorting the corresponding Treasury, however, the nominal rate risk is eliminated and the trade gains exposure only to break-even inflation. And that is the trade here proposed.
From a Strategic Perspective: Get Your Ratio Sharper
In an environment where interest rates rise and inflation surprises to the upside, almost no asset class seems likely to do well. Financial assets are claims on future cash flows, and interest rate hikes decrease the present value of those future cash flows (i.e. they increase the discount rate). In contrast to popular belief, equities underperform during periods of rising inflation as rising interest rates cause the net present value of future cash flows to decrease (though equities do fair better than bonds). As a result, going long break-even inflation is one of the few trades likely to do well in the event of a Fed tightening amidst an acceleration and inflationary economy.
Bridgewater Associates seems to think similarly. According to Pension & Investments, Ray Dalio and his team at Bridgewater Associates recently purchased interest rate swaps in their All Weather risk parity fund to reduce their real yield exposure. In doing so, they have effectively made that fund's TIPS portfolio more a bet on break-even inflation per se rather than on TIPS that suffer from a rise in real yields: precisely the trade proposed here.
The point here is going long BEI creates a risk likely to be rewarded when very few are. Including a long BEI play in your portfolio is therefore likely to increase its Sharpe ratio by decreasing its volatility, even if it's returns are flat. This would be particularly true of most conventional stock and bond-based portfolios, since both underperform during periods of inflation. So if you're interested in generating a more stable return stream from your portfolio and maximizing your Sharpe ratio, including a long position on BEI is probably a good idea.
Putting It On and Wrapping Up
Shorting a 30-year Treasury bond and buying a 30-year TIPS security has for a long time been a trade reserved for institutional investors with access to prime brokers and futures markets. But a new ETF has brought this capability to the retail investor. Launched in January of 2012, the ProShares 30 Year TIPS/TSY Spread provides precisely the exposure to break-even inflation outlined in this article. Seeking returns that correspond to the performance of the Dow Jones Credit Suisse 30 Year Break-Even Inflation Index, the fund goes long a 30-year TIPS security and short a 30-year Treasury and has an expense ratio of only .75%.
This article has made a bullish case for going long 30-year break-even inflation. Any good argument addresses its counterargument: in this case, the proposition that the market is over-pricing future inflation. However, barring an American slide into a pre-Abenomics Japanese deflationary environment, envisioning a circumstance in which inflation in the US over the next 30 years averages less than 2.28% seems difficult. At this point in time, that Japan-style deflationary environment seems very unlikely to transpire in the United States. A decrease in expectations of inflation would also make the trade unprofitable. But that too seems unlikely. So going long US break-even inflation by buying the ProShares 30 Year TIPS/TSY ETF seems likely to be a profitable trade, as well as a risk-reducing portfolio exposure likely to give your Sharpe ratio a steep boost even if its expected returns weren't as enticing.