ECONOMY

‘Distorted’ TIPS Face Reality Check as Fed’s Tapering Looms

There’s a growing sense among bond strategists and investors that Treasury Inflation-Protected Securities’ biggest outperformance since 2009 is at risk.

Firms including UBS Group AG and Aberdeen Asset Management say the Federal Reserve’s $120 billion of monthly bond purchases have disproportionately benefited the relatively thinly traded TIPS market, pushing their yields to deeply negative levels. Meanwhile, investors have been pouring an unprecedented amount of money into funds that invest in the securities, seeking protection from soaring inflation. 

Now, both pillars underpinning the $1.6 trillion TIPS market are coming under pressure. The Fed, which has hoovered up the debt through its quantitative easing, has signaled it may scale back the purchases this year. Inflation, meanwhile, is showing signs of peaking, potentially reducing demand for TIPS as a hedge. 

Inflation expectations fell Tuesday after a report showed the smallest gain in consumer prices in seven months. The data, coming before next week’s Fed gathering, may give the central bank breathing room on its tapering decision, easing calls for a shift as soon as this month.

“The demand for inflation-linked securities has gone through the roof over the last 15 months because headline inflation has been going higher,” said Bhanu Baweja, chief strategist at UBS. “The supply of TIPS has been falling because the Fed has been intervening through its QE. Both will change.”

Calling TIPS one of the most-mispriced assets, Baweja predicts 10-year real yields will rise 50 basis points in coming months, from the current level of about minus 1%. 

Yields on 10-year TIPS, known as real yields, are seen as a pure read on growth because they strip out inflation. They reached an all-time low of minus 1.2% last month and have since risen about 20 basis points, lending weight to the view that real yields — and potentially growth expectations — have finally bottomed out.

Have We Passed Peak Financial Repression?

The Fed’s bond purchases, intended to bolster the economy and keep the bond market functioning smoothly, has left it with 22% of TIPS outstanding, up from about 9% in February 2020. 

Amid a series of elevated inflation readings, the securities have been a hot corner of the bond market. TIPS have returned 4.7% this year, compared with a loss of 1.4% for Treasuries broadly, according to Bloomberg Indices. That would be the biggest annual outperformance in 12 years. 

A byproduct of the Fed bond-buying is that it may have artificially boosted breakeven rates, a widely followed proxy for inflation expectations. The 10-year breakeven rate — calculated by subtracting TIPS yields from nominal yields — is around 2.3%, after reaching a roughly eight-year high of almost 2.6% in May.

“True” inflation expectations are between 1.8% and 1.9% after stripping out the liquidity premium caused by the Fed’s purchases, Deutsche Bank AG strategist Steven Zeng wrote in a Sept. 10 note. That premium may fade quite slowly: If the TIPS market grows at its current rate, it would take 12 years for the Fed’s share to retreat to pre-pandemic levels, by Deutsche’s calculation.

James Athey, who manages $5 billion in fixed-income assets at Aberdeen, said he’s betting that real yields will rise as the Fed pulls back from the market at a time when investor positioning in TIPS is still crowded. 

“Heavily distorted” by the Fed, TIPS will “suffer as the result of the taper,” he said.

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