TIP: The Next Inflation Wave Is Here

Oct. 11, 2021 7:32 AM ETiShares TIPS Bond ETF (TIP)14 Comments
Stuart Allsopp profile picture
Stuart Allsopp
3.58K Followers

Summary

  • The TIP ETF tracks the performance of U.S. Treasury inflation-protected securities, which are government bonds that benefit during periods of high inflation.
  • After a healthy correction over the past few months, and with energy prices soaring around the world, U.S. inflation expectations look set for another leg up, which would benefit TIP.
  • Even if inflation pressures rise, the Fed is unlikely to hike aggressively as this would risk causing a surge in borrowing costs and bursting the equity bubble.
Inflation concept. Bag with a magnifying glass and an up arrow.

gesrey/iStock via Getty Images

In my last update on the iShares TIPS Bond ETF (NYSEARCA:TIP) in late-July I noted that with real yields close to all-time record lows, the risk of capital loss outweighed the potential reward, and I took a neutral stance after being bullish since March 2020. After a healthy correction over the past few months, and with energy prices soaring around the world, U.S. inflation expectations look set for another leg up, which would benefit the TIP ETF.

The TIP ETF

The TIP ETF tracks the performance of U.S. Treasury inflation-protected securities, which are government bonds that pay the holder a lower yield relative to regular bonds but make regular payments based on the prevailing inflation rate. This means that investors in the TIP benefit in two ways from rising inflation. Firstly, it increases the direct payout that they receive from holding the bond, and secondly, it raises the price of the bond if inflation is expected to remain elevated. The TIP has a weighted maturity of around 8 years and a yield of -1.4%, meaning that investors should expect to lose money in real terms if they hold over the long term. However, if inflation expectations rise, as appears likely, the TIP has the potential to generate strong capital gains.

TIP ETF Price

TIP ETF Price

Source: Bloomberg

Inflation Expectations On The Rise Again

The surge in global energy costs over the past month appears to be finally feeding through into U.S. inflation expectations. The 10-year breakeven inflation rate, which tracks expectations of the average inflation rate over the next 10 years based on the yield differential between TIPS and regular bonds, now trades at its highest level since May at 2.5%.

U.S. 10-Year Breakeven Inflation Expectations, %

U.S. 10-Year Breakeven Inflation Expectations

Source: Bloomberg

Over the past four months bond investors have generally regarded the spike in consumer price inflation to be temporary, with 10-year breakevens remaining deeply below the rate of actual CPI prints. The recent spike in oil prices, however, has reignited long-term inflation fears. With headline CPI still almost 3 percent higher than the 10-year breakeven, there is considerable room for breakevens to rise.

The rise in inflation expectations in Europe could be a potential leading indicator of what is to come in the U.S. For instance, in the U.K., which has been hit particularly hard by energy shortages, 10-year breakevens have risen to just shy of 4%.

U.K. 10-Year Breakeven Inflation Expectations, %

U.K. 10-Year Breakeven Inflation Expectations

Source: Bloomberg

While the current energy crisis in Europe has a number of drivers, the surge in prices cannot be detached from the surge in money supply that has taken place over the past 18 months, and there is no sign of a slowdown in U.S. money supply. The ratio of money supply relative to U.S. real industrial production is now back to the highs seen at the height of the Covid recession and suggests that fundamental price pressures are likely to continue rising even if global energy costs subside.

The Fed's Hands Are Tied

The recent weakness in the TIP despite the rise in inflation expectations has been due to the rise in bond yields as investors have begun to price in more aggressive interest rates hikes over the coming years. Even if inflation expectations continue to rise, higher nominal bond yields could undermine the TIP. However, the Federal Reserve has its hands tightly tied as a result of the high level of government and corporate debt in the economy, and its implicit goal of keeping the equity market bubble from bursting. Even in the event that inflation pressures continue to rise, I would expect upside pressure on nominal bond yields to be limited as the Fed looks to prevent a simultaneous surge in borrowing costs and an equity market crash. This would see inflation-linked bond yields move further into negative territory, driving strong gains in the TIP.

Summary

The TIP offers investors protection against rising inflation and the potential for capital gains should inflation-linked bond yields continue to decline. With energy-driven inflation pressures rising globally and the scope for interest rates limited by high levels of debt and an equity market bubble, real yields look set to resume their long-term trend lower. The main risk comes from a resumption of deflation concerns that could accompany any large decline in the stock market, although the TIP would still outperform stocks under such a scenario.

This article was written by

Stuart Allsopp profile picture
3.58K Followers
I am a full-time investor and owner of Icon Economics - a macro research company focussed on providing contrarian investment ideas across FX, Equities, and Fixed Income based on Austrian economic theory. Formerly Head of Financial Markets at Fitch Solutions, I have 15 years of experience investing and analysing Asian and Global markets.

Disclosure: I/we have a beneficial long position in the shares of TIP either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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