In a Catch-Up Trade, TIPS Outperform Treasurys in the 2020 Second Quarter.
Treasury Inflation-Adjusted Securities outperformed comparable maturity straight Treasury securities handily in the 2020 second quarter, posting a total return of 4.2% compared with only 0.8% for straight Treasurys. This performance is noteworthy given that the inflation adjustment on TIPS, which is based upon the change in the headline Consumer Price index, was -0.61% during the quarter. Thus, the total return on TIPS consisted of a 4.8% price gain, offset by the negative 0.6% inflation adjustment.
Yet, the strong relative performance of TIPS represented a partial catch-up after the exceptionally strong performance of straight Treasurys during the 2020 first quarter. In that quarter, straight Treasury’s delivered an exceptionally strong 9.1% annualized return, their strongest quarterly return in the twelve or so years that I have been tracking this market. By comparison, TIPS delivered a respectable, but decidedly smaller first quarter return of 2.7%. It is therefore understandable that returns on Treasurys would pause after such a strong first quarter performance.
The strong relative second quarter performance of TIPS is also noteworthy because it drove the average yield on TIPS into negative territory. By comparison, average TIPS yields have were more negative from the 2011 fourth quarter to the 2013 first quarter, but back then, the negative yields were concentrated across the shorter maturity TIPS in response to a brief surge in the headline CPI. (Investors were willing to accept negative yields at that time because they would still earn a net positive return after the inflation adjustment.) This time around, for the first time ever, the negative yields extend across the entire TIPS yield curve.
Except for the usual noise at the front end, the TIPS yield curve has shifted steadily downward over the past year.
The stronger performance of TIPS and the downshifting of the TIPS yield curve were both a response to the steep drop in straight Treasury yields in response to the onset of the COVID-19 pandemic in March.
Average U.S. Treasury yields are down 157 basis points (bp) on average from a year ago. Across maturities, Treasury yields are down 200 bp or so at the short end and 110 bp at the long end. Most of that decline has occurred over the past six months. Since the end of 2019, average U.S. Treasury yields are down 131 basis points.
The chart above also shows that U.S. Treasury yield curve has barely budged since the end of March. Most of the 2020 second quarter’s 0.8% average return represented coupon income, with average prices mostly flat (or up only slightly).
The stronger advance in TIPS also represented a partial rebalancing toward the historical equilibrium vs. the straight Treasury market. In the 2020 first quarter, average spreads between straight Treasurys and TIPS got severely compressed (to only 30 bp) by the strong rally in Treasurys. That was the smallest spread ever. Consequently, the second quarter rally in TIPS and pause in Treasurys allowed the spread to return to 120 bp, which is about 50 bp below the long-term average spread of 170 bp.
From here, it remains to be seen how TIPS will adjust their yields relative to straight Treasury’s. After declining by 0.67% in April, headline CPI was flat in May and up 0.55% in June. The gains were driven by a sharp recovery in gasoline prices and a more modest increase in food prices. Headline CPI is expected to advance 1.5% in the 2020 third quarter and 1.9% in the fourth quarter, according to the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters, on its way back toward the Fed’s long-term target range of 2.0%.
The future course of the TIPS market is the tail of the straight Treasury market dog. If Treasury yields remain flat, there is some room for TIPS yields to move lower, which would bring the spread between Treasurys and TIPS back to the long-term average of 170 bp (see the July update below). It is unclear whether investors will choose to continue to pay up for TIPS indefinitely and drive their yields further into negative territory; but they would be more likely to do so, if CPI inflation returns to the 2% level, as is currently anticipated in the consensus economic forecasts.
A quicker return to normalized economic activity could cause Treasury yields to rise from their current historically low levels, but that certainly seems less likely at the moment, as evidenced by the decidedly dovish outlook for interest rate policy by the Federal Open Market Committee. If interest rates do normalize, TIPS could suffer lower losses for a time because of the current modestly suppressed spread, especially if inflation picks up, but their returns would still face headwinds in any meaningful normalization of (Treasury) interest rates.
On the other hand, if economic activity remains subdued with expectations that it will take perhaps a few years for the economy to get back to pre-COVID levels, Treasury yields could themselves become negative, which could drive TIPS yields deeper into negative territory.
On the assumption that normalization could occur more quickly than reflected in current consensus views, I believe that TIPS are likely to continue to outperform straight Treasurys over the next few quarters; but outperformance could mean that returns are less negative for TIPS than for Treasurys. For those seeking to put money to work in TIPS, I would concentrate on the short- or medium-term maturities, even though their yields are modestly less negative than on the longer-term maturities. Returns (and thus potential losses) are more sensitive to changes in interest rates on the long end.
With interest rates generally at such low levels, it seems more likely that yields will move higher eventually. While it is certainly possible that yields on both straight Treasurys and TIPS could move even lower, such declines do not seem to me to be more probable at this time.
Update through July 31. In the month since the end of the second quarter, the rally in TIPS has continued. For July, TIPS rallied by between 3 ¼ and 3 ½ points on average, according to my calculations, for a total annualized return of 4.5%. Straight Treasurys meanwhile are up about 1 ¼ points, for an annualized return of 2.9%. There was no inflation adjustment on TIPS during the month of July.
As has been the case so far this year, the greatest returns have been across the long-end of the yield curves for both TIPS and Treasurys. My calculations indicate that long-term TIPS rallied 8 3/8 points during July, while long-term Treasurys advanced about 4 ¼ points.
The rally in both sectors has likewise driven yields down further. At month’s end, the average TIPS yield was -0.92%, down from -0.63% at the end of June or by about 29 bp. That is still not a record low, but close. The average Treasury yield eased to 0.47% in July from June, down about 11 bp. The greater decline in the average TIPS yield cause the Treasury/TIPS spread to widen by 18 bp to 138 bp, which is still below the long-term average of 170 bp.
August 5, 2020
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