Could inflation be heating up?
The trend of tepid developed-economy price pressure has caused some investors to question the overall merits of investing in TIPS. However, we believe that rising breakeven spreads, fundamental dynamics, and policy forces support maintaining a strategic allocation to TIPS.
TIPS BREAKEVEN SPREADS
Against a backdrop of U.S. tax reform, the declining U.S. dollar and higher commodity prices, TIPS breakeven spreads (BES) have been on the rise since mid-December, reversing the trend seen through most of 2017.1 Rising BES indicate expectations for higher inflation and potentially more investor demand for TIPS, and vice versa. TIPS modestly outperformed Treasury securities through 2017, meaning that many TIPS investors did not sacrifice total return performance to maintain inflation protection.2 As investors continue to expect higher inflation, reflected by BES, those who think inflation will trend even higher may benefit from holding a position in TIPS.
The U.S. economy has been steadily growing, supporting our belief that the case for owning TIPS is compelling. Third quarter of 2017 Gross Domestic Product (GDP) growth was 3.2 percent and fourth quarter preliminary estimates reflect growth of 2.6 percent.3 Though the economy expanded at a slower pace than expected, personal consumption and business spending remained strong4 and unemployment hit the lowest rate since the start of the financial crisis. Meanwhile, tax reform is expected to provide added stimulus to the economy. We believe that this combination of GDP growth, low unemployment and expansionary fiscal policy has the potential to spur wage growth, spending and unexpected inflation. Should this be the case, maintaining inflation protection via TIPS may be advantageous if the market ultimately reacts to higher inflation trends, and lagging investors rush to add a position.
An additional source of monetary stimulus in the U.S. is the potential for continued
investment from foreign buyers. If interest rates remain persistently low abroad, then we expect to see a continuation of capital flow into the U.S. as investors seek higher yields. This flow of money into the U.S. from foreign investors may support domestic growth and thereby inflation.
For those debating adding an allocation, we believe TIPS look attractively priced if an investor believes inflation will come in above expectations even after the recent uptick. As seen in the positive GDP growth rate and decreasing US unemployment, the long-term momentum behind economic growth appears to be supported and inflation could unexpectedly follow. Strategies such as the FlexShares iBoxx 3-Year Target Duration TIPS Index Fund (TDTT) and the FlexShares iBoxx 5-Year Target Duration TIPS Index Fund (TDTF) are designed to give investors targeted and purposeful exposure to TIPS while managing duration.
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- 1. In this analysis we are making a comparison between the differences between the 1-Year TIPS rates and the 1-Year nominal Treasury rates, the differences between the 5-Year TIPS rates and the 5-Year nominal Treasury rates and the differences between the 10-Year TIPS rates and the 10-Year nominal Treasury rates in order to construct a U.S. Breakeven 1-Year rate, U.S. Breakeven 5-Year rate and the U.S. Breakeven 10 Year rate using data available as of 1/11/2018. BES measure the difference in yield between similar maturity Treasury yields and the current yields on comparable TIPS.
- 2. Comparison of the Bloomberg Barclays US Treasury Total Return Index and Bloomberg Barclays US Treasury Inflation Notes Total Return Index of 12/29/2017.
- 3. S. Bureau of Economic Analysis, “ Fourth Quarter and Annual 2017 (Advance Estimate)” news release January 26, 2018, https://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm
- 4. Ibid