TIPS Outperform Treasurys Again Even as Inflation Eases
Treasury Inflation-Protected Securities (TIPS) posted an average gain of 3.7% in the 2023 first quarter, better than the 2.4% average gain on comparable maturity straight Treasury securities. The return on TIPS was composed of an estimated average price gain of 285 basis points (bp), interest income of 48 bp and an inflation adjustment of 37 bp.
TIPS outperformed Treasuries across short, intermediate and long maturities. As is often the case in a rising bond market, the gains were graduated across maturity groups, with short maturities posting the smallest gains and long maturities posting the largest gains. The excess returns of TIPS against comparable maturity Treasurys averaged 80 bp on the short end, 90 bp in the intermediates and 240 bp on the long end, according to my calculations.
The average TIPS yield ended the quarter at 1.27%, down 66 basis points (bp) from 1.96% at the end of the 2022 fourth quarter. Average straight Treasury yields ended the quarter at 3.83%, down 33 bp from 4.16% in 22Q4. The smaller decrease in Treasury yields vs. TIPS increased the breakeven spread by 34 bp to 257 bp at March 31 from 223 bp at December 31.
The 23Q1 bond market rally was precipitated by the failures of two regional banks – SVB and Signature Bank – which gave rise to systemic concerns that investors bet will cause the Fed to loosen monetary policy sooner than previously anticipated. The rally in TIPS, however, came amid signs as the quarter came to a close that inflation is continuing to ease. The lower TIPS yields suggest perhaps that investors are accepting a lower real rate of return because the risk of a further increase in yields has diminished.
TIPS yields shifted lower across most maturities in 23Q1 vs. 22Q4, but remain about 150 bp higher on average than 22Q1. Short-term yields for the April and July 2022 maturities fell sharply from the about 3% to -1.1%. as investors and traders apparently bid for safety.
The downshifting of the TIPS yield curve was more pronounced than the downshifting of the U.S. Treasury yield curve during the quarter. As noted, straight Treasury yields declined on average by about 33 bp during the quarter, while TIPS yields fell 66 bp. During the quarter, Treasury yields rose in February due to increased inflation concerns on a high January CPI print. However, regional bank systemic concerns combined with a more moderate increase in February’s CPI sparked an average 50 bp drop in Treasury yields across the 2-year to 30-year maturities by the end of the first quarter.
The decrease in TIPS yields and outperformance vs. Treasurys came despite a decline in the quarterly TIPS CPI inflation adjustment. By my calculations, the TIPS adjustment eased to 0.4% in 23Q1 from 0.6% in 22Q4. Other measures, such as the PCE deflator, support the view that inflation is easing, although that particular measure still shows prices rising at a 4.5% annual rate, according to the latest reading for February, well above the FOMC’s 2% target.
Both TIPS and Treasury yields peaked in 22Q3. The greater decline in TIPS yields represents a reduction in the real rate of interest, which might reflect a reduction in the premium required by investors who previously were worried that interest rates would keep moving higher. With a consensus emerging that the FOMC is nearing a pause in its monetary policy tightening regime, the greater reduction in TIPS yields has helped widen the Treasury-TIPS yield spread. At 257 bp, that spread, which is a hypothetical proxy for long-term inflation expectations, is closer to but still below the current rate of inflation.
April 6, 2023
Stephen P. Percoco
Lark Research
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© 2015-2023 by Stephen P. Percoco, Lark Research. All rights reserved.
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