TIPS Outperform Treasurys Again, But the Decline in the Breakeven Spread May Possibly Be a Signal of an Easing of Inflation Expectations
Treasury Inflation-Adjusted Securities posted a 1.4% average return compared with a loss of 0.2% in comparable maturity straight Treasury securities in the 2021 third quarter. The returns on TIPS were fairly uniform across all maturities. The CPI inflation adjustment of 2.2% more than offset the average annualized yield of -1.50%. Returns on comparable maturity straight Treasurys were more volatile across maturities, with a slight gain in the short maturities, a loss of 0.6% in intermediates and a loss of 0.2% on the long end. The average TIPS yield ended the quarter at -1.33%, up 31 basis points (bp) from -1.64% at the end of the second quarter. Average straight Treasury yields ended the quarter at 1.16%, up 7 bp from 1.09% in 21Q2. The greater increase in TIPS yields vs. straight Treasurys reduced the breakeven spread from the record high of 273 bp at June 30 to 249 bp at Sept. 30. Thus, TIPS investors were apparently slightly less concerned about the outlook for inflation at the end of 21Q3.
The shift in the TIPS yield curve, shown below, may also be supportive of the view that inflation fears have receded a bit. At the end of March, the shortest end of the TIPS curve was significantly negative, with the near-dated April 2022 maturity yielding ‑7.08%. That happens when investors bid the price up to catch a final inflation adjustment payment that will offset the loss of premium. At the end of June, the yield on the near-dated July 2021 TIPS maturity fell further to ‑11.34%, a sign that investors were scrambling a bit more for inflation protection. But at Sept. 30, the nearest-dated January 2022 TIPS yield had risen to ‑2.56%, a level consistent with other short-dated maturities.
This improved sense of calm is also – for the moment at least – reflected in U.S. Treasurys. Although long-term Treasury yields fell from July to mid-August, they rose steadily to the end of September, leaving the Treasury yield curve largely unchanged from the second to the third quarter. Yields were higher across the intermediate maturities, but mostly unchanged on the short- and long-ends.
Compared with the March 31 yield curve, rates were moderately lower across the long-end of the curve. If indeed the outlook calls for sustained high inflation, it is surprising that long maturity straight Treasury yields are still below their March 31, levels. Furthermore, changes in investor sentiment are often most evident in returns on the long-end of the curve. After seeing double-digit swings in 21Q1 and 21Q2, the return on the long-term Treasurys in 21Q3 was the smallest in absolute terms since 2015.
As already noted, the rise in TIPS yields (to a less negative level) drove a 24 bp decline in the breakeven spread to 249 bp. Most of that decline was driven by the rise in yield on the nearest-dated TIPS from ‑11.07% in 21Q2 to -2.56% in 21Q3. Excluding the 21Q2 nearest-dated TIPS from the calculation lowers the 21Q2 average spread from 273 bp to 254 bp, so that spreads across all of the remaining TIPS maturities declined only by 5 bp during 21Q3. However, the average spread across the intermediate maturities rose by 8 bp to 251 bp, an indication of slightly higher inflation expectations from 2026 to 2032 (but still below 2.5% on average).
Supporting the negative yields on TIPS that now span the entire maturity spectrum is the expectation of continuing high inflation adjustments, which are based upon changes in the headline CPI (with a two-month lag).
The quarterly TIPS adjustment has averaged more than two percent in each of the past two quarters. Although the year-over-year change in headline CPI has averaged about 5% for the past five months (through August, the latest period for which data is currently available), it has eased from a recent peak of 5.39% in June to 5.37% in July and then to 5.24% in August.
Market concerns have most recently focused on the rise in the prices of natural gas and oil. Natural gas is trading at its highest level since 2010; oil is at its highest since 2015. The recent rise in natural gas prices has been driven by increased worldwide demand, especially in Europe, due to the hot summer and need to replenish storage in advance of the coming winter season. Although there is sufficient worldwide supply to meet that demand, Russia has limited its supplies into Europe, choosing only to honor its contractual commitments, to ensure acceptance of its newly-constructed Nord Stream 2 gas pipeline, which is opposed by the U.S. and some European countries, in part due to fears of overreliance on Russia as a supplier of natural gas to Europe.
The spike in the price of oil is the result of rebounding worldwide demand as the pandemic recedes combined with continuing supply constraints on the part of OPEC. With prices this high, however, it is likely that worldwide producers, including the U.S. and even OPEC producers needing to repair their economies, will step up their production over time.
Looking at the charts, the recent leveling off of the price of natural gas (as seen in the near-dated futures contract), could signal a top. The price of oil has not yet shown any clear sign of a top, but the steepness of the advance is unsustainable, as technical indicators begin to signal that it is approaching overbought territory.
Because of their widespread use throughout the economy – oil for gasoline and heating oil and natural gas for heating, generating electricity and as a feedstock in numerous industrial processes – the reverberations from price increases in these commodities will continue to be felt for some months. However, if their prices are at peak levels, their contribution to inflation will begin to recede before long.
Certainly there are other concerns about inflation: Widespread supply chain dislocations have sparked price volatility across a wide range of goods and services; house prices have seen record high appreciation rates driven by low mortgage rates and pent-up demand; prices for many industrial metals are up (even though many have receded in recent months); and wages in the U.S. are increasing at their fastest pace since before the 2008 financial crisis. The near- to intermediate-term outlook for price changes caused by these factors will be determined mostly by global economic growth. With the negative impact of the Delta variant and receding pandemic-driven fiscal stimulus provided by most developed economies, the slowing of economic growth should also serve to ease inflationary pressures.
The consensus of economists, according to the 2021 third quarter Survey of Professional Forecasters from the Federal Reserve Bank of Philadelphia, estimates that headline CPI averaged 5.2% in the third quarter and anticipates that it will decline to 2.6% in the fourth quarter. For all of 2021, the forecasters see an average increase of 4.9% in headline CPI; but expect that the average annual increase will slow to 2.4% in 2022 and then to 2.3% in 2023. Of course, this outlook for 2021 is significantly higher than what the forecasters had anticipated at the beginning of the year; but there is currently no clear evidence at this time that the current pace of inflation will be sustained in 2022 and 2023. The 21Q3 rise in TIPS yields and decline in the breakeven spread are supportive of that view.
Barring any unforeseen changes in the economic landscape, inflation expectations should begin to ease back toward pre-2021 levels. It is likely then that TIPS yields will rise over time as headline CPI declines. If this is a gradual process, then the offset between the two should result in returns that are roughly comparable to holding straight Treasurys.
However, if the economy continues to advance toward full employment and U.S. GDP growth recedes toward a more sustainable rate around 2.5%, straight Treasurys would likely produce negative returns as interest rates normalize. Returns on TIPS returns would presumably follow Treasurys’ lead.
October 5, 2021
Stephen P. Percoco
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