The Loss in TIPS Matches Treasurys in the 2023 Second Quarter as Inflation Continues to Ease
Treasury Inflation-Protected Securities (TIPS) posted an average loss of 1.4% in the 2023 second quarter, equal to the estimated 1.4% average loss on comparable maturity straight Treasury securities. The return on TIPS was composed of an estimated average price loss of 310 basis points (bp), interest income of 30 bp and a positive inflation adjustment of 140 bp.
TIPS performance was roughly in line with Treasuries across all maturities. In the final two months of this quarter, the losses were in intermediate maturities were noteworthy as the yield curve became slightly less inverted, following the Fed’s decision to pause in raising the target Fed Funds rate. For the quarter, TIPS saw modestly worse returns than Treasurys in the short- and intermediate maturities, but lower losses in the long maturities.
The average TIPS yield ended the quarter at 2.07%, up 80 basis points (bp) from 1.27% at the end of the 2023 first quarter. Average straight Treasury yields ended the quarter at 4.31%, up 48 bp from 3.83% in 23Q1. The smaller increase Treasury yields vs. TIPS reduced the breakeven spread by 33 bp to 224 bp at June 30 from 257 bp at March 31.
The increase in TIPS yield coincided with the slowing of inflation during the quarter. Increases in both the Consumer Price Index and the Personal Consumption Expenditures deflator, which is the Federal Reserves preferred measure of inflation, continued to slow during the quarter, clear evidence that inflation is easing. However, no one is quite ready to declare victory in the fight against inflation.
TIPS yields shifted higher across most maturities in 23Q2 vs. 23Q1, but the increase was most pronounced on the short end of the TIPS yield curve.
As noted, straight Treasury yields rose on average by about 48 bp during the quarter, while TIPS yields rose 80 bp. Most of the increase came on the short end of the TIPS yield curve where the average yield rose by 126 bp to 2.45%. Intermediate TIPS yields increased by 57 bp to 1.74%; while long-term TIPS yields increased by 17 bp to 1.67%. Although the bp increase was smaller across the long maturities than long Treasury yields, it was comparatively more consequential to returns.
The decrease in TIPS yields and outperformance vs. Treasurys came despite an increase in the quarterly TIPS CPI inflation adjustment from 0.4% in 23Q1 to 1.4% in 23Q2. However, the TIPS adjustment is likely to be lower for the balance of the year.
May’s headline CPI increase was 0.25%, bringing the annualized three-month moving average to 4.44%, down from 6.97% in March. If May’s increase is replicated in each of the remaining months of 2023, I calculate that the TIPS CPI adjustment will be 0.76% in both the third and fourth quarters. That equates to an annualized CPI adjustment of 3.0%, which is above the current TIPS spread of 224 basis points.
The easing of CPI inflation is mirrored in the PCE deflator. The annualized 3-month average increase in the PCE deflator slowed from 4.4% in February to 2.5% in May. The core PCI deflator also slowed from 5.1% to 4.2% over the same period, but remains above the Federal Reserve’s target of 2.0%. TIPS 23Q2 losses and the decline in the breakeven spread suggest that investors expect a further easing in inflation.
Both TIPS and Treasury yields reached new multi-year highs in 23Q1. The average TIPS yield has not been this high since the years immediately preceding the 2008 financial crisis, a period when the Fed was raising interest rates. TIPS investors apparently want more current income to compensate for lower expected inflation and also perhaps the uncertainty that interest rates could yet move higher. Nevertheless, from a historical perspective, TIPS yields are attractive at current levels.
My previous report (2023 First Quarter TIPS Performance) contained an error in the pricing of long-term Treasury security that was significant enough to meaningfully alter the estimated returns on TIPS. With that error, I had previously estimated the 23Q1 return on long-maturity Treasurys (2040-2053 maturities) to be 3.4% and the quarterly return for all Treasurys to be 2.4%. With the correction, the 23Q1 return on long-maturity Treasurys is 5.9% and the total return on all Treasurys is 3.1%. A copy of the corrected table is provided below:
July 3, 2023
Stephen P. Percoco
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© 2015-2023 by Stephen P. Percoco, Lark Research. All rights reserved.
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