- Straight Treasurys earned 2.9% in the 2019 third quarter, better than the 1.8% return on TIPS.
- Straight Treasury yields fell 27 bp on average to 1.74%, while TIPS yields slipped 2 bp to 0.43%.
- The inflation adjustment was 0.4% in the quarter.
- The breakeven spread fell 25 bp to 131 bp.
- With breakeven spreads at the low end of their historic range, TIPS seem like a better value than straight Treasurys.
Treasurys Outperform TIPS in the 2019 Third Quarter
Comparable maturity straight Treasurys outperformed Treasury Inflation-Protected Securities (TIPS) in the 2019 third quarter. On average, Treasurys earned a return of 2.9% in the quarter, better than the 1.8% return on TIPS.
On a price basis, straight Treasurys significantly outperformed TIPS. The average TIPS yield slipped 2 basis points (bp) in the quarter to 0.43%, while average Treasury yields fell 27 bp to 1.74%. This quarter, the CPI inflation adjustment averaged only 40 bp, down from 152 bp in the 2019 second quarter.
While the average yield on TIPS declined 2 bp to 0.43%, there were meaningful differences in yield changes across maturities. Average yields on short-term TIPS increased 17 bp from 0.45% to 0.62%, as investors drove up yields to compensate for the lower inflation adjustment. Yields on intermediate-term TIPS declined by 7 bp to 0.21% and long-term TIPS yields declined by 22 bp to 0.53%. The drop in long-term TIPS yields mirrored the trend in straight Treasurys and was the primary driver of overall total returns.
The chart below shows the shifts in the TIPS yield curve for the second and third quarters of 2019 compared with year-end 2018. At the short end of the curve, small changes in price typically have a big impact on yield. Accordingly, the shortest maturity TIPS have swung wildly from positive in 18Q4 to near zero in 19Q1 and have become increasingly positive in 19Q2 and 19Q3. The swings are due primarily to investors adjusting prices and returns on short maturity TIPS in response to changes in the inflation adjustment. They are willing to accept negative yields on short-term TIPS when they anticipate a solidly positive CPI adjustment, but require positive yields when the CPI adjustment will be small or perhaps even negative.
Moving out on the TIPS yield curve, TIPS yields have shifted lower with each passing quarter, essentially following the performance of straight Treasurys. Those moderate downshifts in yield have produced solid returns on intermediate- and long-term TIPS so far this year.
The decline in straight Treasury yields in 19Q3 was less significant than in 19Q2, but it was still meaningful, especially across the longer maturities. The average Treasury yield across all maturities fell 27 bp to 1.74%. Short-term Treasury yields fell 16 bp to 1.66%, apparently anticipating a continued easing of Federal Reserve policy. Intermediate-term Treasury yields declined 28 bp to 1.63%; while long-term Treasury yields declined 40 bp to 2.07%. The declines implicitly reflect increasingly lower expectations for long-term inflation. During the quarter, media reports buzzed about the possibility of Treasury yields turning negative in the not too distant future.
The greater decline in Treasury yields caused the spread between TIPS yields and Treasury yields to fall by another 25 bp from 156 bp in the 2019 second quarter to 131 bp in the 2019 third quarter. The spread measures the average expected inflation rate. It is also called the breakeven inflation rate that would make investors indifferent to owning TIPS or straight Treasurys. If an investor believes that actual inflation will be higher than the breakeven spread, she would prefer to own TIPS (because she would get a greater total return with a higher inflation adjustment). On the other hand, if she thinks that actual inflation will be lower than the spread, she would prefer to own straight Treasurys.
Since 2009, the TIPS-Treasury spread has averaged 175 bp and the quarterly change in the spread has averaged 38 bp. So far this year, the quarterly change in the spread has averaged 49 bp, higher than the historic average, and the quarterly change has declined with each passing quarter. Initially, the volatility was correlated to the changes in inflation adjustment on TIPS (which is determined by the change in the benchmark headline CPI). In the 2019 third quarter, however, the inflation adjustment moved closer to the current annual rate of inflation, which has dampened volatility.
The recent gyrations in the inflation adjustment have been due primarily to the impact of changing energy prices (most notably oil and gasoline) on inflation. While the benchmark West Texas Intermediate price of oil fell 45% from October 2018 to December 2018, it rebounded 57% from December to May and has settled into a trading range of roughly $54-$60 per barrel over the past five months. Likewise, the volatility in gasoline prices has subsided, as gasoline has moved into a trading range over the past five months. This has helped temper changes in the headline CPI.
Treasurys have now outperformed TIPS for two consecutive quarters. If interest rates continue to fall, as many economist now fear, Treasurys will continue to outperform. Over the long haul, however, I do not believe that low inflation is sustainable. Eventually, I believe, barring a structural shift in the economy and financial markets, the TIPS-Treasurys spread should return to its long run average of 175 bp. Consequently I continue to view TIPS as attractive versus Treasurys.
October 21, 2019
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