2022 Returns on TIPS

TIPS Outperform Treasurys Once Again in 22Q1 as Inflation Surges

Treasury Inflation-Protected Securities (TIPS) posted a 2.9% average loss better than the 6.6% average loss in comparable maturity straight Treasury securities in the 2022 first quarter.  The losses on TIPS were more muted than those on straight Treasurys across all maturities. However, losses were greatest in the longest maturities for both TIPS and straight Treasurys, as is often the case during periods of rising interest rates.

The return on TIPS was driven by an estimated average price decline of 4.9% offset by average contractual quarterly interest income of 0.2% and a 1.6% gain from the CPI inflation adjustment.

Losses on comparable maturity straight Treasurys were significant but graduated across maturities, with a 3.6% loss in the short maturities, a 6.7% loss in intermediates and a 12.5% loss on the long maturities.

The average TIPS yield ended the quarter at -1.32%, up 30 basis points (bp) from -1.62% at the end of the 2021 fourth quarter.  Average straight Treasury yields ended the quarter at 2.32%, up 105 bp from 1.27%, in 21Q4. The greater increase in Treasury yields vs. TIPS increased the breakeven spread by 75 bp to yet another record high of 364 bp at March 31 from 289 bp at December 31.

Thus, the attractiveness of the inflation protection afforded by TIPS helped to cut 2022 first quarter losses in half (vs. straight Treasurys).  TIPS have now outperformed straight Treasurys for eight consecutive quarters and for more than three consecutive years.

TIPS vs US Treasurys 22Q1

Except for the very shortest end of the maturity spectrum, TIPS yields shifted higher across most maturities in 22Q1 vs. 21Q4. Short-term yields for the April and July 2022 maturities, plummeted to -9%, as investors and traders apparently do the math to determine the total return including the impact of expected CPI adjustments up to the maturity date.

It is important to note that small changes in price have a significant impact on yields at these very short maturities and also that my yield calculations are based upon “asked” prices. So, for example, the 0.125% TIPS due April 2022 were quoted 100 5/16-100 3/8 at March 31 with only two weeks to maturity and the remaining inflation adjustment of a little over 7/16 of a point already set. That extra 3/8 of a point in the asked price works out to a -9.5% annualized yield (according to Excel’s yield function), excluding the inflation adjustment.

TIPS Yield Curve 22Q1

The upshifting of the TIPS yield curve mirrors to a lesser degree the significant shift in the U.S. Treasury yield curve during the quarter. Straight Treasury yields steepened sharply from the one-month to two-year maturities. The yield on the one-month maturity increased by only 11 bp to 0.17%; but the two-year yield surged by 155 bp to 2.28%. The two-year yield is generally seen by the fixed income markets as an indicator of Federal Reserve policy. According to the CME’s Fed Watch tool, Fed Fund futures suggest a probability of greater than 90% that the Fed Funds policy rate will be at least 2.25% by the end of 2022.

The increase in yields across Treasury maturities greater than two years was significant, but not as significant as the rise in the two-year yield. As a result, the Treasury yield curve flattened considerably during the month of March. During the course of March, gyrations in Treasury prices caused various configurations in the yield curve, including at times slight inversions with longer maturity yields falling slightly below shorter maturities. This has precipitated considerable chatter in the media about the possible elevated risks of recession and concerns about whether the Fed can engineer a soft landing. Up until 22Q1, the Fed’s public comments have focused on its efforts to boost employment and its belief that the pick-up in inflation would be temporary. Now, the emphasis seems to be more clearly on fighting inflation, with steady rate increases expected during the course of the year and perhaps even a quicker unwinding of the Fed’s balance sheet.

US Treasury Yield Curve -Mar. 31, 2022

The greater decline in straight Treasury yields vs. TIPS yields drove a 75 bp increase in the breakeven spread to 364 bp, another record high.

TIPS vs. Treasurys Yields and Spreads 2009-2022

The strong relative performance of TIPS was driven by expectations of higher interest rate adjustments going forward. The quarter’s adjustment of 1.6% was the third highest in more than a decade.  Given the recent pick-up in headline CPI and expectations that it will continue for at least the next couple of quarters, I anticipate that the inflation adjustment could be as much as 2.5% in 22Q2, which would be the highest in decades.

Quarterly CPI Inflation Adjustment for TIPS - 2016-2022

Similar to the Fed, I have been expecting that inflation would begin to recede this year; but the fallout from Ukraine, especially the efforts by Europe to reduce its dependence on Russia’s oil and natural gas, have driven oil and natural gas prices to eight-year highs. Along with recent increases in food prices (also influenced by Ukraine’s importance as a wheat producer), this has stoked inflation, driving it higher this year, despite early signs that some of the factors that contributed to the pick-up in inflation in 2021, such as supply chain disruptions, are starting to ease.

It is entirely possible that inflation will recede when a negotiated settlement between Russia and Ukraine is reached. The recent pullback of Russian forces from Kyiv opens the door a little wider to a resolution. However, it may still take a few months or longer for the parties to negotiate a deal. Even if a resolution is reached, it probably will then take more time for the sanctions against Russia to be lifted before oil and natural gas prices begin to fall back.

Perhaps the only consolation is that prices have to continue to go up for inflation to remain high. If oil stabilizes, even at these high levels, then inflation will eventually recede (even though it will take time for the increases to make their way completely through the global economy). If inflation remains elevated for a long time, expectations about long-term inflation will move higher, presenting more of a challenge for the Fed.

For now, the more recent acceleration in inflation is beginning to take a toll on the economic outlook. Business and consumer sentiment surveys indicate that while current conditions are still quite good, there are greater concerns about the outlook for six months from now.

The inflation outlook and associated expectations of rising short-term interest rates are presumably already reflected in TIPs pricing vs. Treasurys. Inflation probably has to remain elevated for TIPS to continue to outperform. If, however, the futures markets are right and Fed Funds reach 2.25%-2.50% by the end of the year, the short end of the U.S. Treasury yield curve will rise steadily for the remainder of the year, putting greater pressure on borrowers, especially those with variable-rate debt. That would likely slow the economy and could lead possibly to an inversion of the yield curve (assuming that long-term inflation expectations also recede).

TIPS have already had a record three year run of outperformance vs. Treasurys. Although it is possible that TIPS may continue to outperform for the next few quarters or even longer, it seems highly likely that this winning streak will eventually end.

Quarterly Returns on TIPS vs Treasurys - 2018-2022
FRD 5Yr 10yr TIPS Spreads - 2008-2022

April 6, 2022

Stephen P. Percoco
Lark Research
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Linden, New Jersey 07036
(908) 975-0250

© 2022 by Stephen P. Percoco, Lark Research.   All rights reserved.