TIPS: Deflated Expectations, Inflated Opportunity?

Prices for U.S. Treasury Inflation Protected Securities ( TIPS ) suggest inflation will be the same over the next 10 years as over the past five. We think that is too pessimistic.

Something is stirring in the inflation-protected securities markets. According to data provider Markit, a record $2.3 billion flowed into U.S. TIPS exchange traded funds during the first quarter of 2016.

Is U.S. Inflation "Stirring" or Just Volatile?

In mid-February the 10-year breakeven inflation rate hit a post-financial crisis low of around 1.2%. Since then TIPS inflows have taken it up to 1.6%. Even so, we think bond markets are still underpricing long-term U.S. inflation risk, implying attractive value in TIPS.

Certainly, a range of measures of U.S. inflation have ticked up lately. Core CPI, which excludes volatile elements such as food and energy prices, is now running at 2.2%. Even the headline number, including the big fall in oil prices , is almost at 1%. Doubters point to the failure of near record-low unemployment to feed through into a meaningful pay rise for U.S. workers, however.

Bond Markets Are More Pessimistic About Long-Term Inflation than Other Forecasters

Bond markets are clearly among those doubters. There are other places to look for long-term inflation expectations, however, and they offer a revealing perspective.

The Philadelphia Fed Survey of Professional Forecasters' estimate of the 10-year CPI rate predicts an annualized rate of around 2.1%. The University of Michigan survey of consumers' median inflation expectations for the next five to 10 years remains above 3%. A relatively new benchmark, the Federal Reserve Bank of New York's survey of consumers' median inflation expectations over three years, predicts a rate of around 2.6%.

The 10-year market breakeven rate at 1.6% is lower than all of these. In fact it is at the same level as the trailing five-year average for headline CPI. In other words the bond market is forecasting another decade of the low inflation we have seen over the past five years-a very cynical view of the Fed's capacity to stimulate the economy.

Of the two components of the CPI-the fast-moving energy and food prices and the slow-moving core components-it is the latter that bond markets have tended to correlate with more closely. The 10-year breakeven rate and the realized core CPI rate have diverged, but they always converge again relatively quickly.

The Long-Term Bond Market Breakeven Inflation Rate Has Tended to Converge with Core CPI

Source: Bloomberg, Neuberger Berman. Data as at March 31, 2016.

Today's 1.6% 10-year breakeven rate is closer to the headline CPI reading of 1.0% than the core reading of 2.3%. Moreover, the low headline number is a reflection of the fact that energy inflation is running at -13%, a year-over-year move that we are unlikely to see repeated over the next 12 months. Back in mid-2014, the 10-year breakeven inflation was above the Fed's 2% target. Since then, however, bond markets have obsessed over two things. The first is oil and its slide from $100 to sub-$40 per barrel. The second is the U.S. dollar, up 20% over the same period.

Recent stabilization of both the oil and dollar trends has coincided with big inflows into TIPS investment products, but the fact that the 10-year breakeven inflation rate still languishes at 1.6% suggests that markets are either finding it difficult to relinquish their oil-and-dollar fixation, or taking a severely pessimistic view of the economy and of central banks' powers to manage it.

Until they take a longer-term view again, U.S. TIPS will continue to offer compelling value potential.

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