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I have been asked this question with some regularity: "I bought some TIPS recently in anticipation of rising inflation, and they have gone down in value. What gives?"
First, the facts. As shown in the chart below, yields on TIPS have been increasing, but not as abruptly as yields on nominal Treasury securities.
10-Year Yields: TIPS vs. Nominal
Source: U.S. Treasury Department
Just looking back to the beginning of April, yields on regular 10-year Treasuries have risen from 3.91% to 4.85% -- almost a full point. Yields on 10-year TIPS have risen about 70 basis points, from 1.48% on April 1 to 2.18% on May 13.
So the good news is that TIPS have not been hit as hard as regular Treasuries. The bad news is that they have been hurt. The reason is that much of the recent rise in interest rates is not due to changes in the longer-term view of inflation. The increase in interest rates is due to increases in real rates, which reflect the improving economy and greater demand for capital.
The gap between the two shows that expectations about long-term inflation had not changed much until quite recently.
Delta Between 10-Year Yields on TIPS and Nominal Treasuries
Source: Darcy Bradbury
A simple way to think about longer-term inflation expectations is to compare yields on nominal and inflation-indexed 10-year notes. (Economists have a more complex calculation, but this comparison is accurate enough for our purposes.) As this chart shows, the market's views about inflation over the next 10 years did not change much even while the real yields were climbing on 10-year notes. The gap averaged about 2.45% until a week or so ago.
This makes sense. Nothing we've seen in the inflation or GDP or employment numbers suggested that anything had really changed over the longer term about our nation's economy. Inflation has actually averaged a bit above 2.5% over longer periods of time.
What had changed were views about economic activity. If the economy was really starting to rebound, then demand for capital should rise, and real interest rates would also have to go up. Indeed, there was record corporate borrowing until May, and the extraordinary federal borrowing is also pressuring the markets. So what we saw happening in rising rates throughout April into early May was real rates of return rising toward more normal levels.
Short-term rates reacted more directly to the discussion about a potential rise in the federal funds rates. The Federal Reserve has had its foot on short-term rates, and when rates move, this will have a direct impact -- regardless of inflation -- on borrowing costs for dealers, funding strategies and liquidity. But yields on longer-term debt moved a little differently.
But the second chart on the gap in yields shows an interesting development over the past week or so as the gap has widened. Suddenly, the market is reflecting different views about long-term inflation. What has changed during this time? Only time will tell, but the biggest culprits I see are energy costs and related fears about greater instability in the Middle East.
Anyone who has filled a gas tank recently understands what has happened with energy costs, and as I said in a February column, the Fed can't control energy costs. Energy costs are more reflective of the geopolitical environment, and that seems to be getting less stable in the past couple of weeks. Although I've tried to avoid the gruesome pictures in the news recently, our efforts in Afghanistan and Iraq certainly have not made Middle East oil supplies safer or cheaper yet. And there's no end to the conflict in sight. That's the kind of picture that can change long-term views about the risk of inflation.
Darcy Bradbury is a partner in a private investment firm in New York City and has had a 25-year career in finance and government. At time of publication, neither Bradbury nor her firm held positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Bradbury cannot provide investment advice or recommendations, she welcomes your feedback at