Treasurys Outperform TIPS Again in 22Q3, Another Sign of Moderating Inflation Expectations
Treasury Inflation-Protected Securities (TIPS) posted a 6.9% average loss in the 2022 third quarter, better than the second quarter’s 7.6% average loss and modestly worse than the 6.6% average loss on comparable maturity straight Treasury securities. TIPS underperformed Treasurys across the short and long maturities, but outperformed Treasurys across the intermediate maturities.
This quarter’s results were skewed a bit by the inclusion of the newest TIPS issue, the 0.625% TIPS due August 15, 2032. New TIPS sometimes have partial quarterly returns that are more volatile than the TIPS average. Excluding the 0.625s of 2032, TIPS lost 7.0% in the quarter vs. -6.0% for Treasurys.
The return on TIPS was driven by an estimated average price decline of about 9% offset partially by an average 2.5% gain from the CPI inflation adjustment. The average TIPS yield was near zero at the start of the quarter and so did not contribute meaningfully to the 22Q3 quarterly return.
Like TIPS, the losses on comparable maturity straight Treasurys were graduated across maturities, with a 2.6% loss in the short maturities, a 7.4% loss in intermediates and a 10.7% loss on the long maturities. The quarter’s loss on intermediate Treasurys widened as the yield curve inverted.
The average TIPS yield ended 22Q3 at 1.98%, up 185 basis points (bp) from 0.13% at the end of 22Q2. Average straight Treasury yields ended the quarter at 4.05%, up 102 bp from 22Q2. TIPS and Treasury yields are the highest since I began tracking TIPS in 2009. The greater increase in TIPS yields vs. Treasury yields reduced the breakeven spread by 82 bp from 290 bp at June 30 to 208 bp at Sept. 30. The drop in breakeven spreads is a sign of moderating long-term inflation expectations.
The underperformance of TIPS implies that inflation expectations moderated for a second consecutive quarter. Breakeven spreads declined across all maturities: Short maturity spreads fell 160 bp from 360 bp in 22Q2 to 200 bp in 22Q3. Intermediate spreads eased by 11 bp to 217 bp. Long-term spreads declined also by 11 bp to 210 bp.
The 160 bp decline in short-term spreads was driven by a nearly 300 bp increase in short-maturity TIPS average yields. For a second consecutive quarter, short-term TIPS investors expressed a preference for higher yields rather than inflation-protection. The increase in TIPS yields is reflected across the TIPS yield curve, as shown above, most dramatically in the swing in very short-term yields from negative to positive during the course of the year.
As shown in the chart above, the U.S. Treasury yield curve inverted during 22Q3. At Sept. 30, yields across the short- and intermediate maturity Treasurys from six months to seven years are now higher than the yields on the 10-year and 30-year Treasury bonds. The spread between the 10-year and 2-year Treasury yields is now negative and matches the low recorded in 2000.
According to the CME’s Fed Watch tool, the futures markets are anticipating a Fed Funds rate of 4.35% for December (based upon weighted average probabilities), up from 3.08% currently. That represents another potential increase of 127 bp on the short end of the curve. Since the yield curve has inverted with this last 75 bp Fed Funds increase, the Treasury yield curve will probably invert more if the CME’s rate forecast proves true. TIPS Investors seem more worried now about interest rate hikes than inflation.
This quarter’s CPI adjustment was 2.48%, down 35 bp from 22Q2’s record 2.83%. The easing of the adjustment was due mostly to the slight decline in the headline CPI in July. Since the headline CPI posted another small decline in August, it seems likely that CPI adjustment will moderate further in 22Q4. This expectation seems to be a catalyst for the 22Q3 underperformance of TIPS, as reflected in the 82 bp decline in the end-of-quarter breakeven spread.
The evidence is mounting that inflation is receding. The Reuters/Jeffries CRB Index, a broad-based measure of commodities prices, is down 14.4% (through October 6) from its intraday peak of 329.13 on June 9. The CRB Index had been down as much as 19.8%, but it has rebounded sharply over the past eight trading sessions, mostly because of the rise in crude oil prices following the announcement that OPEC+ will cut production by two million barrels. Although the natural gas futures price has also risen modestly over the past three days, it is down 30.5% from its mid-August highs.
The decline in commodity prices extends beyond oil and natural gas. Coffee, copper, corn, gold, lumber, silver, soybeans, sugar and wheat are all below their earlier 2022 highs. The strength of the U.S. dollar also counteracts inflation by reducing import prices.
Much of the increase in inflation over the past year and a half has been attributed to supply chain disruptions. Yet, an affiliate of the New York Fed recently reported that its index of supply chain pressures declined sharply again in September (as shown in the chart below). The WSJ reported last week that ocean carriers in Asia have cancelled dozens of sailings during the peak season.
Trans-pacific shipping rates are down 75% from year-ago levels.
Although the evidence continues to mount that inflation is easing, the Fed has so far signaled that it intends to continue raising the target Fed Funds rate. In their most recent forecasts, FOMC members anticipate that the Fed Funds rate will increase to 4.26% by year-end (based upon weighted-average estimates at the mid-point of the target ranges). With the average target rate now at 3.00%-3.25%, that implies another increase of 100 bp-125 bp over the next two meetings.
Although inflation is clearly slowing, Fed speakers have recently emphasized the importance of quelling inflation expectations, which may require setting interest rates higher than may be otherwise warranted and keeping them there for some time, perhaps a year or longer. Of particular importance is slowing the pace of wage increases, which have been running above 5% year-over-year for the past 12 months. Although the data show that job gains are slowing, they remain uncomfortably high and probably serve to sustain the increases in average wages. Yet, news reports indicate that the number of job openings has declined sharply in recent weeks, as has the workforce quit rate. With interest rates where they are, it seems likely that the tightness of the labor market will continue to ease in the months ahead.
For these reasons, I believe that there is sufficient evidence for the Fed to at least taper the pace of its rate increases and pause soon to allow the financial markets and the economy to adjust to the new interest rate regime. In my view, the Fed should signal that rates are unlikely to decline from current level, even if inflation falls back to the 2% level, because this is where rates should normally be. The economy cannot sustain excessive monetary accommodation indefinitely. Normalized rates should serve to protect against many of the market dislocations that have arisen over the past 15 years, including excessive house price appreciation.
A pause in raising interest rates will allow the FOMC to gauge the impact of this year’s rate increases to help avoid a severe pullback in economic activity. Should high inflation rates prove to be persistent (or if new dislocations occur that prevent inflation from abating), the FOMC can still respond by raising interest rates later as necessary.
Assuming for now that the FOMC will follow through on the forecasts of its members. I anticipate that both TIPS and comparable maturity straight Treasury securities will again post declines in 22Q4, with a further contraction in the breakeven spread. Once the FOMC pauses, Treasurys and TIPS might rally initially (as the fear of future rate increases subsides), but their returns should become positive – equal at least to their current yields (plus, in the case of TIPS, the CPI inflation adjustment).
October 7, 2022
Stephen P. Percoco
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Linden, New Jersey 07036
© 2022 by Stephen P. Percoco, Lark Research. All rights reserved.
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