Afraid of Inflation? I've Got Some 'TIPS' on What Not to Do

We missed the TIPS trade earlier this year. I've frankly been surprised at how quickly inflation risk has become a consensus narrative after decades of weakness. From this point forward, TIPS --Treasury inflation-protected securities -- offer extremely poor risk/reward. I'd call it the most overvalued segment of the bond market. Clients are constantly asking me how to protect their portfolios against rising inflation, but TIPS aren't the answer. In fact, shorting TIPS is probably a better inflation hedge than being long. Here's why. TIPS 'Breakeven' Explained TIPS are Treasury bonds structured such that the principal value of the bond increases each year commensurate with the increase in the Consumer Price Index (CPI). So, if CPI increases by 2% in the bond's first year, the par value of the bond will also increase by 2%. As a rough approximation, you can say that the TIPS performance will ultimately be equal to its yield, plus the average annual change in CPI over its life. We use the term breakeven to describe what level of CPI would make the TIPS return exactly equal to a standard Treasury of the same maturity. In essence this means that the breakevens are a pretty good estimate of what the market thinks CPI will be on average over some period of time. Right now the 5-year TIPS breakeven is 2.53% and the 10-year is 2.30%. Both are at or very close to 10-year highs. Breakevens are a pretty good estimate of what the market thinks Consumer Price Index will be on average over some period of time. Note that TIPS reference the total CPI, for example, the one that includes food and energy. The Federal Reserve prefers Core PCE. Therefore if we want to see how TIPS breakevens relate to the Fed's inflation target, we need to try to convert one to the other. If we pull out the effect of food and energy, Core PCE tends to run about 0.2%-0.3% below CPI. Over the last decade food and energy have been a net drag on CPI, but if we assume going forward those items are neutral on average, 0.2%-0.3% is a pretty good approximation for the difference. For those interested, this gap is mainly because PCE includes employer-paid health insurance while CPI does not. That suggests the TIPS market is projecting Core PCE to be about 2.2%-2.3% over the next five years and 2.0%-2.1% over the next 10 years. Breakevens Probably Can't Rise Much More Under the Fed's new average inflation targeting (AIT) approach, it will allow inflation to run somewhat above its stated 2% target for some time. Exactly how much above target hasn't been formally announced, but based on several Fed officials' speeches, 2.5% seems to be the consensus. As long as you assume the Fed still takes its price stability mandate seriously, it can be assumed the Fed won't tolerate an extended period of inflation above 2.5%. That essentially puts an absolute ceiling of where a five or 10 year average inflation rate could be. Sure, maybe peak inflation reads are above 2.5%, but it seems difficult to see how inflation averages over 2.5% if the Fed is going to actively combat inflation rising that high. The longer time horizon you consider, the less likely an average of 2.5% becomes. The Fed is quite literally targeting an average inflation rate over some long period of time at 2%. Betting on inflation being a lot higher than that is betting that the Fed can't control inflation if it wants to. We have 30 years of low inflation, suggesting the Fed certainly can control inflation. Again using that same 0.2%-0.3% CPI/PCE adjustment, it suggests that TIPS between five and 10 years can only rise between 50 basis points and 20bps. That 50bps number is probably a bit too high for the 10-year TIPS, but we'll use that for now. What If Growth Continues? The reason why inflation expectations have risen in recently months is of course because the economic outlook has improved so dramatically. This is likely the reason why so many investors are asking about TIPS right now, presuming that if the economic outlook keeps improving, inflation expectations will also keep rising. But as we said above, there is a logical limit to how high inflation will actually go. So what happens if the economy surprises to the upside? Instead of turning into higher inflation expectations, it will result in the market expecting more Fed hikes. For investors, this means that real yields will start rising while inflation expectations either stay steady or could even fall. When real yields rise, TIPS perform exactly the same as Treasuries, namely, the price falls. So if your thesis is that the economy is going to outperform current market expectations, TIPS are a bad buy. They will likely lose money right alongside traditional Treasuries. If your thesis is that the economy is going to outperform current market expectations, TIPS are a bad buy. They will likely lose money right alongside traditional Treasuries. And, they are a bad buy if the economy disappoints, too. Note that TIPS are also a bad buy if you think the economy might disappoint. In that case, the breakeven will fall and TIPS will either fall in price or at least underperform standard Treasuries. Now there are some who argue that inflation will be meaningfully higher than this 2.5% ceiling I've described. The arguments fall into two big categories: the Fed being unwilling and the Fed being unable. What If the Fed Fails to Hike Rates? Some observers think inflation will be considerably higher going forward, because the Fed will be unwilling to raise rates in the face of such a large U.S. debt load. In other words, that the Fed will be forced by circumstances to suppress interest rates in service of the Treasury, inflationary consequences be damned. I can't prove this won't happen, and there is historic precedent. The Fed artificially suppressed yields during World War II and extricating itself from this arrangement took until 1951. But I'd point to how far rates have risen since September. Given numerous opportunities to comment on this rate movement, Fed Chair Jerome Powell has been consistent. As long as rates are rising because of economic optimism, he doesn't care. If the Fed were planning on manipulating rates all across the curve, I think he'd be singing a different tune, even now. Another possibility, shared by serious investors from Bridgewater to Blackrock , is that the Fed may not be able to control inflation, at least not quickly. I have some sympathy for this idea. If the Fed waits until Core PCE hits 2.5% before hiking at all, there's a good chance inflation has some momentum by that time. It could therefore keep rising for some period before rate hikes ultimately take hold. After all, monetary policy is said to operate with long and variable lags. Ergo the effects of rate hikes won't be felt for months or even a year or more after the hike actually happens. This has little effect, however, on what long-term inflation expectations should be. As long as the Fed remains committed to average inflation being around 2%, some short period where inflation rises even to 3% or more, should be followed by a period of tighter policy. Furthermore, betting on an extended period of high inflation ignores some big secular factors that have held inflation down for decades. Things like demographics, globalization, technology enabling easy price comparison, etc. Shorting TIPS This trade isn't going to make you rich, but for anyone who wants to make a fixed income bet on the economy accelerating, shorting TIPS is probably your best trade. Because inflation breakevens are already so high, this short is more attractive than just shorting regular bonds: The 10-year Treasury yield is in the 76% percentile over the last 10-years, the TIPS breakeven is in the 99th percentile. The outright yield is also extremely low, making the cost of holding the short relatively attractive. And the risk is also lower than owning the Treasury, since TIPS also probably don't perform well if the economy disappoints. The only caveat is that the inflation narrative could become even more prominent if there's a short-term inflation spike late this year. In that case, TIPS could deviate from the fair value analysis I've presented here even more. I'm comfortable enough with the story to enter the trade now, but I'll have some extra dry powder in case the opportunity gets even more attractive down the road.

Afraid of Inflation? I've Got Some 'TIPS' on What Not to Do

Tip No. 1: Beware of Treasury inflation-protected securities. Let me explain.

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