Inflation has been a trending topic recently. We have seen a period of price deflation measured by the Consumer Price Index (CPI), a widely accepted benchmark for measuring price inflation. Some argue that the COVID-19 crisis will shift the U.S. into a structurally lower inflation paradigm. Some believe inflation will take off in the next couple of years thanks to the unprecedented scale of the Federal Reserve’s (Fed) quantitative easing (QE), large government fiscal spending and the potential U.S.-China decoupling. Let’s find out which view the financial markets support.
Treasury inflation-protected securities (TIPS) are a type of U.S. Treasury security. TIPS principles are indexed to the CPI, so the owners are protected from price inflation. In general, if price inflation expectations move higher, TIPS outperform nominal Treasury securities and vice versa. As this week’s chart shows, TIPS have outperformed nominal Treasury securities for the last several months. Since April, inflation expectations have started to recover along with the U.S. economy. For example, derived from TIPS, the 5-year inflation expectation has climbed from 0.2% in March to 1.4% in July. It has not reached its pre-COVID-19 level, which was around 1.7%. There is room for TIPS to extend recent outperformance.
From this week’s chart, we can also see that if investors had invested in intermediate nominal Treasury securities, the return would have been muted. This is because the front end to the belly of the interest rate curve has been under the tight grip of the Fed. However, the Fed is more than happy to see inflation expectations rising. It has been supportive of TIPS through QE purchasing. Because of this dynamic, I prefer intermediate TIPS over the nominal Treasury securities for the near future. For the long end of the interest rate curve, the Fed exerts much less control. Even though long TIPS are likely to outperform the long nominal Treasury securities as well, long TIPS are susceptible to interest rates moving higher.
Another tailwind for intermediate TIPS is that the Fed is contemplating adjusting the inflation targeting framework. With the adjustment, the Fed would allow inflation to temporarily overshoot its 2% target. Intermediate inflation expectations would benefit most since the overshooting is not likely to happen too soon, but it would also not be tolerated for long.
Key Takeaway
For the last several months, TIPS have consistently outperformed nominal Treasury securities. The financial markets have been pricing in higher inflation expectations. Nonetheless, the expectations are still below the pre-COVID-19 level. The inflation debate will not be settled any time soon. Consumers seem to anticipate higher inflation. According to surveys conducted by the University of Michigan, consumers expect next year’s inflation rate to exceed 3%. However, the Fed’s resume does not provide any assurance. The central bank has been very successful in taming inflation, but it has never been able to convincingly lift inflation.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
Opinions and statements of financial market trends that are based on current market conditions constitute judgment of the author and are subject to change without notice. The information and opinions contained in this material are derived from sources deemed to be reliable but should not be assumed to be accurate or complete. Statements that reflect projections or expectations of future financial or economic performance of the markets may be considered forward-looking statements. Actual results may differ significantly. Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate.
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