2022 Returns on TIPS

Treasurys Outperform TIPS in 22Q2 Despite the Surge in CPI Inflation

Treasury Inflation-Protected Securities (TIPS) posted a 7.6% average loss in the 2022 second quarter, worse than the 4.3% average loss on comparable maturity straight Treasury securities.  The losses on TIPS exceeded those on straight Treasurys across all maturities.  Double-digit losses were posted across the longest maturities for both TIPS and straight Treasurys, as is usually the case during periods of rising interest rates; but losses on long maturity TIPS were especially high.  This was the first time in over two years (nine quarters) that straight Treasurys outperformed TIPS.

The return on TIPS was driven by an estimated average price decline of 10.5% offset by average contractual quarterly interest income of 0.2% and a 2.8% gain from the CPI inflation adjustment.

Like TIPS, the losses on comparable maturity straight Treasurys were graduated across maturities, with a 0.9% loss in the short maturities, a 3.4% loss in intermediates and a 12.7% loss on the long maturities.

The average TIPS yield ended the quarter at 0.13%, up 145 basis points (bp) from ‑1.32% at the end of the 2022 first quarter.  Average straight Treasury yields ended the quarter at 3.03%, up 81 bp from 2.32%, in 22Q1. The greater increase in TIPS yields vs. Treasury yields reduced the breakeven spread by 77 bp from the record high of 364 bp at March 31 to 290 bp at June 30.

This relative performance suggests that inflation expectations have moderated, especially across the longer maturities.  Breakeven spreads eased across all maturities, with short-term spreads declining nearly 100 bp from 459 bp in 22Q1 to 360 bp in 22Q2, intermediate spreads declining by 69 bp from 307 bp to 238 bp and long-term spreads declining by 38 bp from 259 bp to 221 bp.

Yields, Spreads and Returns on US Treasury Inflation-Protected Securities vs. Comparable Maturity Treasury Securities for the 2022 Second Quarter, according to estimates by Lark Research from data published in the Wall St. Journal.

Although the longer-term spreads declined by the smallest amount, the drop was still consequential in terms of performance.  The average yield on long-term TIPS increased by “only” 113 bp, but that increase from a 0% yield at the start of the quarter had a big impact on price, owing to the longer duration.  Long-term TIPs declined on average by nearly 26 points in price, from about 121 at the start of the quarter.  In 22Q1, TIPS investors opted for more yield than inflation protection.

Yield Curves for U.S. Treasury Inflation Protected Securities for Dec. 31, 2021, Mar. 31, 2022 and Jun. 30, 2022, from Lark Research via the WSJ.

The sell-off in TIPS is evident from the upshift of the TIPS yield curve during the quarter.  The sell-off was more muted at the short end of the curve.  The yield on the July 2022 0.125% TIPS became more negative, even though its price declined, because any price above par with only 15 days left to maturity has an outsized negative impact on yield.  Other than that anomaly, all other TIPS yields rose.  The average TIPS yield increased by 145 bp to 0.13%, more than the average 71 bp increase in the yield on comparable maturity straight Treasurys.  The average TIPS yield is now positive for the first time in more than two years (nine quarters).

As shown in the chart below, the U.S. Treasury yield curve has flattened as it has shifted higher.  In 22Q2, it shifted up by 120 bp on average across the short end and by 65 bp across the 2-year to 30-year maturities.  The greater increase on the short end was directly attributable to the FOMC’s hike in the target Fed Funds rate.  Although the one-month T-Bill rate of 1.28% is now 30 bp below the Fed Funds rate of 1.58%, the rest of the short-maturity bills and notes, from two months on out, are above the current Fed Funds rate.  The short-end of the curve will probably continue to move higher in lock-step with the FOMC’s target Fed Funds rate.

According to the CME’s Fed Watch tool, the futures are expecting (based upon weighted average probabilities) a Fed Funds rate of about 3.40% for December, up from 1.58% currently.  That represents a potential increase of 180 bp on the short-end of the curve.  How the rest of the yield curve responds depends upon the course of the economy and how the FOMC reacts.  If slowing inflation is a precursor to a slowing economy, then the Fed may ratchet down its rate hike expectations.  Alternatively, if the Fed does not back down in the face of slowing inflation, the yield curve may invert.  TIPS 22Q2 performance suggests that investors may be more worried now about the Fed rate hikes than inflation.

U.S. Treasury yield curves at Dec. 31, 2021, Mar. 31, 2022 and Jun. 30, 2022, compiled by Lark Research from U.S. Treasury data.

The 22Q2 relative underperformance of TIPS came despite a record quarterly CPI adjustment of 2.83%.  April’s headline CPI reading, the first of three for the third quarter CPI adjustment, showed a resurgent monthly increase of 1.1%.  Assuming that the monthly increases moderate from the April level to say 0.75% in June and 0.50% in July, the third quarter TIPS adjustment would be 2.38% in 22Q3, which would rank as the second highest on record.  At this time, further moderation of the CPI adjustment seems likely if the broad-based declines in commodity prices that have taken place in recent weeks hold.

The Quarterly CPI Inflation Adjustment on U.S. Treasury Inflation-Protected Securities, 2016 to 2022 as calculated by Lark Research from the U.S. Bureau of Labor Statistics data.

Supporting this view, the Reuters/Jeffries CRB Index, a broad-based measure of commodities prices, is down 11.3% from its intraday peak of 329.13 on June 9 to its most recent closing price of 291.83 on July 1.  Over roughly the same time frame, the CME’s continuous contract for West Texas Intermediate crude oil is down 12.3% and its natural gas continuous contract is down 40.7%.  Both the declines in oil and natural gas suggest that at least a temporary resolution of the war in Ukraine is more likely now.

Declining commodity prices are not limited to oil and natural gas.  Futures prices for wheat, a commodity directly impacted by the war in Ukraine, are down 34% since mid-May.  The price of corn, which had started to slide in late April, has fallen 23.3% from mid-June.  Soybean prices are down 21.8% since June 9.

Gold is down 13.3% from its intraday high of March 3 and is currently retesting its May 16 intraday low.  Prices for palladium, platinum and silver have largely mirrored the decline in gold.

Copper has fallen 21.3% since June 3.  The continuous contract for lumber futures has fallen 50% since its January 14 intraday high, but is up 30% from this year’s intraday low on June 14.  The declines in copper, lumber and the broad range of commodities suggests that besides the alleviation of pressures caused by the war in Ukraine and concerns about the impact of interest rate increases on economic activity, supply chain pressures may be easing.

Such broad-based declines may point the way to lower inflation in the quarters ahead, but there probably will be residual pressures, such as wages, that keep inflation above its pre-pandemic, pre-Ukraine levels.  Although the general decline in inflation would ease pressure on the world’s central banks, the Fed should maintain short-term rates at 1.50%-3.00%, as long as the economy can tolerate interest rates above the zero bound.  That would be good for the U.S. economy and for other economies around the world, as it would be a sign that it is possible for interest rates to normalize.  Normalized interest rates should also help to address the various bubbles that have been blown up, most notably in house prices, by excessively accommodative monetary and fiscal policies, and make it less likely that they will recur.

Of course, I may be reaching these conclusions too soon.  Certain key events that would support a reduction in inflation and normalization of interest rates still must play out.  New developments could keep inflation high and financial markets on edge.  Nevertheless, these recent developments, including especially the decline in commodity prices and yes, the underperformance of TIPS, are a positive development for investors.

Quarterly Returns on U.S. Treasury Inflation-Protected Securities vs. comparable maturity straight U.S. Treasury Securities: 2018-2022, as calculated by Lark Research from data provided by the Wall St. Journal.
Yields Spreads Between U.S. Inflation-Protected Securities and U.S. Treasury securities for 5-year and 10-year constant maturities, as calculated by Lark Research from U.S. Federal Reserve data.
Yields, Spreads ad Returns on U.S. Treasury Inflation-Protected Securities vs. comparable maturity U.S. Treasury securities for the quarter ended March 31, 2022, as estimated by Lark Research from data published in the Wall St. Journal.

July 3, 2022

Stephen P. Percoco
Lark Research
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