By Kevin Muir of “The Macro Tourist” fame; reposted here with permission
I was early in calling for an increase in breakevens and a decline in bond prices. No denying it. But at least I stuck with it and didn’t get shaken off. Heck, I even reiterated the call earlier this year – Breakeven Refresher Lesson.
Since then, breakeven inflation rates have been steadily rising.
So here we are with the market finally pricing in increased inflation rates. Whereas a couple of years ago pundits were filled with worries about disinflation, today the opposite concern dominates financial airwaves.
Has the market gotten ahead of itself? Or is inflation about to take off?
To be truthful, I don’t know. When markets were forecasting little increase in inflation, taking the other side of their skepticism was easy. But today we are faced with higher breakevens, and even more alarmingly, higher real rates.
It used to be easy to be confident that inflation rates would rise. The Federal Reserve was reluctantly tightening, and quantitative tightening was still only a discussion point for FOMC meetings instead of a harsh reality.
Yet today is much different. The Federal Reserve is relatively tight – at least for a post Great-Financial-Crisis world. Short rates are trending higher and the Federal Reserve is adhering to their schedule of winding down their balance sheet.
Will this be enough tightening to derail the economy and usher in the next recession? I don’t know. But the odds have increased.
Yet at the same time, years of extreme monetary stimulus have created an environment where the potential for a spark to ignite an inflationary bonfire should not be understated.
The risks on either side of the inflation equation have increased. Understanding how TIPS, US Treasuries and breakevens behave under different scenarios has never been more important.
An investor’s returns in TLT, TIP and RINF
This year has seen a rather vicious decline in bond prices. And now that we have had a large move in bonds and inflation breakeven rates, I thought it would be instructive to take a moment to have a look at returns of various fixed-income ETFs during this period.
Before any dyed-in-the-wool bond geek chastises me for using TLT as a bond proxy, let me beat you to it – I get it. True bond traders scoff at using an ETF to gain bond exposure.
Yet in this case, trading breakeven spreads is difficult, so the RINF ETF (explained in the Breakeven Refresher Lesson post) is the easiest way to replicate this exposure for everyone except the most sophisticated bond traders. Therefore let’s maintain consistency and compare it to other fixed-income ETFs.
Let’s start with the examining the returns of TLT (the government Treasury bond ETF) versus TIP (the Treasury-Inflation-Protected-Security ETF) year-to-date (I know the durations aren’t matched, bear with me):
Wait! A negative total return in TIP? TIPS are supposed to protect you in a rising inflation environment. The bond market is pricing in an increasing amount of inflation, so what’s going on? Shouldn’t TIPS be doing well?
Well, that’s the result of the increase in real rates. Don’t forget that TIPS pay a coupon plus the inflation rate. The TIPS yield is called the real rate because it is the amount an investor would earn on top of inflation. However, a 10-year TIPS investor has owned an asset whose yield has risen from 0% to almost 1.00% over the past couple of years. Like a regular bond holder who realizes a decrease in the value of their bond as rates rise, TIPS holders are not immune to a decline in market value when real rates rise. This increase in real yields means that even TIPS have suffered during this bond bear market.
It didn’t have to be this way. If real yields had remained unchanged, then a TIPS owner might have earned the inflation coupon and come out slightly ahead. The important thing to realize is that TIPS protect you from only the inflation component of nominal interest rate increases.
That’s why for Kodiak-grizzly bond bears like me, owning TIPS was not a great option. To capture the increase in breakeven rates, a long position in TIPS was required, but a short position in nominal US Treasuries was also necessary. That’s why RINF was a much better choice for those that believed inflation breakevens would rise. Here are the total year-to-date returns for TIP versus RINF:
That’s the sort of protection an inflation bull is looking for. Instead of being down almost 200 basis points, RINF is almost 600 basis points higher. That’s a difference of approximately 800 basis points.
Where do we go from here?
I don’t have any answers as to the next move in bonds and breakeven rates. We are awfully oversold with lots of speculative accounts leaning short. It wouldn’t surprise me if the next move is for bonds to rally (and most likely see breakevens decline).
Although my short-term forecast is uncertain, I have a long-term one. Eventually, the Federal Reserve will lose control of inflation expectations. When that happens, owning TIPS might not be a winning trade in absolute terms, but rather simply offer relative protection versus traditional bonds from a rising inflation environment. If you want to profit from this widening, you need to have the other side of the trade on too. You have to be long TIPS, but also short Treasuries. Owning TIPS outright is not good enough.