Treasury Inflation-Adjusted Securities recorded lower losses than comparable maturity straight Treasury securities in the 2021 first quarter. According to my estimates, TIPS posted an average loss of 2.7%, compared with an average loss of 6.3% on comparable maturity Treasury securities. Despite the losses, TIPS yields went further into negative territory, with the average TIPS yield declining from ‑1.28% at December 31, 2020 to ‑1.40% at March 31, 2021. Meanwhile. the average Treasury yield increased from 0.65% to 1.23%. With TIPS and Treasury yields moving in opposite directions, the Treasury-TIPS spread (aka the breakeven) surged from 192 basis points (bp) at year-end 2020 to 263 bp at 21Q1. This quarter’s inflation adjustment, measured by the quarterly change in the headline CPI, was 0.46%.
This quarter’s average TIPS yield was the lowest since I began tracking the TIPS sector in 2009. This was also the highest quarter end breakeven spread recorded over that time period. (By comparison, the long-term average breakeven spread is 170 bp.) The combination of lower TIPS yields and higher breakeven spreads suggests strong demand from investors for inflation protection.
Most of the decline in the average TIPS yield in 21Q1, as in other recent quarters, is explained by the drop in yields across shorter-maturity TIPS, as shown in the table above. Average short-term TIPS yield fell nearly 100 bp to -2.72%, while intermediate TIPS yields increased (i.e. became less negative) by 21 bp to 1.11% and long-term TIPS yields also increased by 48 bp from -0.44% to +0.04%.
By comparison, the U.S. Treasury Yield curve shifted higher again across the longer maturities, as shown in the chart below. Short-term Treasury yields increased 16 bp to 0.31%. Intermediate Treasurys rose 72 bp to 1.35% and long-term Treasury yields jumped 85 bp to 2.35%. The yield on the 10-year Treasury rose 81 bp to 1.74% and the 30-year yield rose 76 bp to 1.41%.
The rise in long-term Treasury yields was the primary driver of the average negative return of ‑6.3% across all comparable maturities in 21Q1. By my calculations, long-term Treasurys posted an average loss of 18.9%.
By comparison, TIPS posted an average loss of 2.7%. Here too, losses on long-term TIPS were the primary driver of those losses. I estimate that long-term TIPS lost 11.3% in value during the quarter.
As noted, with the further decline in TIPS yields and the rise in comparable Treasury yields, the average spread between Treasurys and TIPs, which is also known as the breakeven spread, increased to a record 263 bp.
The rally in TIPS yields throughout 2020 and continuing into 2021 has been fueled by rising inflation expectations. The Federal Reserve has encouraged this by saying it will keep interest rates lower for longer, even if inflation runs above its long-term target of 2% for a time. In 2020, one of the main catalysts for inflation fears was the steady decline in the U.S. dollar; but the dollar’s decline has been reversed so far in 2021.
Another inflation catalyst is the price of oil, which doubled from the early November lows to early March. Oil has since given back some of its gains recently, with the price of a barrel of West Texas Intermediate falling from a high of $68 in early February to about $59 at quarter’s end. The recent rise in oil will cause a temporary boost to inflation as prices for oil and its intermediate and end products, like gasoline, reverberate through the economy. For now, this boost in inflation looks temporary and inflation should subside, as long as oil does not continue to rise from current levels.
Meanwhile, natural gas prices, another potential inflation driver, have remain subdued despite record U.S. demand from the cold weather in February. Natural gas production remains steady at 92 BCF per day, which should serve to keep a lid on prices for now, even though natural gas in storage is below the five-year average level.
The headline Consumer Price Index (CPI) (for the All Urban Consumer or CPI-U), which is the index that determines the inflation adjustment on TIPS, increased 1.23% in 2020. By comparison, the CPI-U rose 1.81% in 2019 and 2.44% in 2018.
The 21Q1 CPI inflation adjustment was 0.46%, down slightly from 0.50% in 20Q4. The rise in commodity prices could cause a faster, but most likely temporary, rise in the CPI over the next couple of quarters.
The consensus of economists, according to the latest Survey of Professional Forecasters from the Federal Reserve Bank of Philadelphia, anticipates that headline CPI will average 2.2% annually for the next three years. The Survey was last published on Feb. 12 and is updated quarterly. The 2.2% annual headline CPI forecast equates to an average quarterly inflation adjustment of 0.545%, modestly above the amount recorded for 20Q1.
At this point, I am offering no opinion about the performance outlook for TIPS versus Treasurys. Although certain insights can be gained by comparing current yields and spreads to the longer-term averages, it is not clear whether these historical relationships will hold up over the intermediate term, given the COVID-19-related changes in the financial environment – including the large Federal stimulus spending and the Federal Reserve’s ongoing accommodative monetary policies. Without a strong conviction on the performance outlook, I am opting simply to provide the facts (as I calculate and estimate them) for now.
April 2, 2021
Stephen P. Percoco
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