Treasury TIPS Are Still a Bad Bet

In recent weeks, I've been arguing that the U.S. Federal Reserve has shifted strategy away from preemptively fighting inflation and into a more-reactive approach. Logically, one would assume that this raises the risk that inflation overshoots. If the Fed is going to be reactive, there is at least a chance that inflation pressure has already built into the system by the time they recognize it, resulting in higher inflation.

While I acknowledge that is a risk, I still don't think investors should bet on intermediate-term inflation being much higher than it is now. In particular I think TIPS (Treasury Inflation-Protected Securities) remain a bad bet. Here's my take.

The Fed Hasn't Abandoned Inflation Targeting

It is important to distinguish between what the Fed is and isn't doing here. They are no longer trying to preempt higher inflation merely because unemployment is low. This isn't because they are less concerned about inflation or because they are targeting higher inflation. It is a combination of two reasons:

1. The Fed is no longer confident in the link between low unemployment and inflation.

2. Because rates are as low as they are, the Fed feels that they are more capable of reacting to inflation quickly enough to prevent it getting out of control, whereas they may not have the ammunition to fight a recession.

Ergo, they'd rather risk a little inflation by leaving rates a bit too low, as opposed to risk a recession by hiking a bit too fast.

That being said, should inflation actually rise meaningfully above 2%, even for three or four months, the Fed isn't going to ignore that. Perhaps the fact that they are being reactive results in somewhat more short-term inflation volatility, but I don't expect it to result in higher long-term inflation. 

In the Short-Term, TIPS Are Just a Deleveraged Oil Play

You often hear about trades as being "leveraged" to something else. In this case, TIPS are deleveraged to oil. The chart below shows the 10-year TIPS breakeven vs. WTI crude prices.

The "breakeven" for a TIPS is basically the CPI rate it would take for the TIPS to result in the same return as a traditional Treasury over the life of the bond. So in this case, it is the average CPI rate over 10-year that you need just to breakeven vs. buying a normal Treasury bond.

That correlation looks awfully tight, doesn't it? Measured daily over the last two years, the correlation is 0.93. Very tight. And really, this should be no mystery.

There is a reason why economists like to pull food and energy out of the CPI and look at the "core" measure. Food and energy are the most volatile elements of the CPI, hence it is probably best to ignore short-term fluctuations. But the flip side of this is that these volatile elements are exactly the ones that are driving short-term fluctuations in inflation.

Hence ,TIPS are really just a bet on oil, and a very low-volatility bet, at that. In the chart above, the TIPS breakeven falls to about 1.7% before rebounding to about 1.95%. If you bought the TIPS and hedged it with a traditional Treasury, you would have made about 2% for this trade. However oil was up about 49% from its Christmas Eve low until today.

You needed a nearly 50% increase in the commodity to eek out a 2% gain in TIPS. Do you want to bet on oil rising from the $60s to the $90s just to make another 2%? And if that is your view, aren't there better ways to play it?

TIPS Aren't a Great Longer-Term Inflation Hedge

My supposition is that while the risk of CPI running at 2.3%-2.5% for a few months is somewhat higher under the Fed's new strategy, the risk of inflation running any higher than that is no different. With inflation breakevens already at 1.95%, how high does inflation have to run in order for the TIPS to be a great trade? 2.5%? 3%? And remember, it can't just print at that level for a little while, it needs to average at that level for the life of the bond.

With the global economy seeming to be running slower, the chance of inflation suddenly jumping to 3% seems low. And beyond that, the chance the Fed completely ignores that jump and just allows inflation to run that high is zero.

A hedge is something that should produce a material payoff should some kind of risk occur. TIPS just don't have the volatility to produce a big payoff, either in the breakeven or the resulting price action. I don't like them for a trade, nor do I like them as a long-term hedge.

At the time of publication, Graff had no positions in any of the securities mentioned.