In a Wild Quarter, U.S. Treasurys Significantly Outperform TIPS
In what was a historically volatile quarter across all financial markets, U.S. Treasurys significantly outperformed TIPS. Treasurys earned a 9.1% total return in the quarter, much better than the 2.7% return for TIPS. The extraordinary gains in Treasurys stemmed from the sharp drop in yields across the curve as investors sought safety from the COVID-19 pandemic. Meanwhile TIPS yields increased only slightly, mostly on the short end of the curve, due to tempered inflation expectations. The sharp decline in Treasury yields pushed the Treasury-TIPS breakeven spread to 30 basis points, an 11-year low.
As in the 2019 fourth quarter, the greatest returns in both TIPS and Treasurys were realized on the long end of the yield curve. Long maturity TIPS earned a very strong 8.5% in the quarter, while comparable long maturity straight Treasurys earned an astounding 17.3%. Returns were more muted on the short end, with TIPS posting slightly negative returns. Comparable short maturity straight Treasurys earned a respectable 3.2% in the quarter.
The average Treasury-TIPS spread tumbled to 30 basis points (bp) from 163 bp in the 2019 fourth quarter. That is far below the long-term average breakeven spread of 170 bp. In fact, the 30 bp spread is the lowest since the 2008 financial crisis (when the spread actually turned negative). Likewise, the 133 bp quarter-to-quarter drop in the spread is one of the biggest on record.
While yields on the short end of the TIPS curve are often volatile, the long end of the curve has been shifting downward steadily for the past year, mirroring the trend in straight Treasurys. The wide swing in short-maturity TIPS yields from negative a year ago to positive currently reflects expectations of lower inflation. Investors are less willing to accept low yields on TIPS when the inflation adjustment is expected to be low (or even negative).
The quarterly inflation adjustment, determined by the year-on-year change in the headline Consumer Price Index, has eased over the past few quarters. In the 2020 first quarter, it was only 20 bp, down from 30 bp in the 2019 fourth quarter and 40 bp in the 2019 third quarter. If the recent plunge in oil prices is sustained, the inflation adjustment could be negative for at least one or two quarters going forward.
The sharp drop in the breakeven spread is evident in both the 5-year and 10-year constant maturity TIPS. So far at least, the spread has not fallen to the lows of the 2008 financial crisis.
While the breakeven spread has fallen to levels reminiscent of the 2008 financial crisis, its causes and composition are markedly different today. In 2008, the compression of the spread was driven by the sharp rise in TIPS yields, as some investors were forced to liquidate their positions quickly. In fact, the spread became sharply negative across the short- to intermediate maturities in November 2008. For example, the Treasury-TIPS spread at the 5-year constant maturity bottomed out at -212 bp, according to my calculations of Federal Reserve data. It seems obvious now that TIPS were a screaming buy back then.
This time around, the compression in the Treasury-TIPS spread has been driven by falling yields on straight Treasurys. On average, TIPS yields have held steady, with rising yields across the short maturities and falling yields across the longer maturities. The current low 30 bp spread, which is well below the 11-year average of 170 bp, suggests that TIPS are a better buy (relative to straight Treasurys), especially since annual inflation while almost certainly be higher than 0.3% in the years ahead.
Yet, it is tough to predict how, when, or even whether the spread will return to normalized levels. If we accept the consensus view that the negative economic effects of COVID-19 will recede in the second half of the year, then yields on straight Treasurys should begin moving back to pre-COVID-19 levels. If accompanied by a return of inflation back toward the Fed’s 2% target, then TIPS yields should ease a bit on the short end of the yield curve, while longer-term TIPS yields will rise in step with long Treasurys. Most likely then, TIPS will suffer negative returns, but not as negative as Treasurys.
If, on the other hand, the course of COVID-19 turns out to be different from the current consensus, or if other factors or events should alter the expected trajectory of the economy, then the performance of TIPS, both absolute and relative to Treasurys, may be different in ways that are difficult to predict today.
Update. Since the end of the 2020 first quarter (through April 21), the overall gains in Treasury and TIPS prices and corresponding decrease in yields have continued. However, TIPS have outperformed Treasurys during this period. By my calculations, TIPS have rallied about one-quarter point on the short end to as much as 8½ points on the high end over the past three weeks. Their average yield has declined by over 16 bp to 0.14% during this time. Comparable maturity straight Treasurys, meanwhile, have been roughly flat on the short end to up as much as 5½ points on the high end and their average yield has eased by 7 bp to 0.53%. As a result, the Treasury-TIPS spread has widened by 9 bp to 39 bp.
By my calculations, the stronger performance of TIPS so far in April has doubled their YTD return to 5.4% from 2.7% at the end of the first quarter. Straight Treasurys, on the other hand, have improved their YTD return to 10.6% from 9.1%.
Although it is tough to draw firm conclusions about a 9 bp widening of the breakeven spread, it is nevertheless surprising (to me at least) that TIPS would perform better than Treasurys this month, given the recent sharp drop in the price of oil.
April 22, 2020
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