The iShares TIPS Bond ETF (NYSEARCA:TIP) has mounted a strong recovery over the past few months as bond yields have moved sharply lower. This has outweighed the impact of lower inflation expectations, which typically act as a drag on inflation-linked bonds. I argued in my previous article that the strength in stocks and credit spreads posed a short-term risk to the TIP and bonds in general as the Fed has rarely cut rates amid strengthening risk appetite. However, despite the rapid easing in financial conditions, breakeven inflation expectations have fallen back to two-year range lows. This decline in inflation expectations has created an opportunity for investors to shift out of regular Treasuries and into the TIP, particularly as oil prices look set for a rebound.
The TIP ETF
The TIP tracks the performance of US Treasury inflation-protected securities, with a weighted average maturity of 7.1 years and an effective duration of 6.6 years, which puts the TIP in the mid-range in terms of duration and volatility across the inflation-linked bond universe. Since my last article on the TIP, the real yield has declined from 2.6% to 1.9% currently as nominal yields have fallen much faster than inflation breakeven.
From a long term perspective, the 1.9% real yield is highly attractive in the context of slowing trend real GDP growth and surging government debt relative to GDP. As I argued back in August, there is simply no way the US Treasury can continue to fund its spending at these high real interest rates without a drastic cut in spending. I fully expect real yields to fall back below zero over the coming years, which should result in strong total return gains for the TIP.
Falling Inflation Expectations At Odds With Risk Rally
Over the past two decades there has been an exceptionally strong inverse correlation between high-yield corporate credit spreads and 10-year breakeven inflation expectations. As financial conditions ease, inflation expectations tend to rise and vice versa. The past three months have seen inflation expectations move sharply lower, back to their two-year range lows, even as credit spreads have tightened considerably. This has created a great opportunity for investors to gain exposure to a recovery in inflation expectations via inflation-linked bond funds such as the TIP.
One trigger for a recovery in inflation expectations could be a recovery in oil prices. Front-month WTI has mounted a slight recovery in recent weeks, breaking above down trendline resistance, and according to Goldman Sachs data CTA traders hold large net shorts, and would be forced to become large buyers on any up move.
Main Risk Comes From Sustained Fed Pause
The main risk to the TIP is that the Fed keeps rates on hold for longer than expected. Fed funds futures are now pricing in an aggressive easing cycle in 2024, with almost 160bps of rate cuts expected. If we were to see inflation expectations recover strongly this would be unlikely to undermine the TIP as it would keep downside pressure on real yields. However, there is a risk that continued strong risk appetite prevents the Fed from easing while inflation expectations continue to ease. Such a move could result in losses for the TIP in 2024, however, from a risk-reward perspective the ETF remains highly attractive.