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TIPS: The Benefits Of A Misunderstood Asset Class

To me, a wise and humane policy is occasionally to let inflation rise even if inflation is running above target.”
~Janet Yellen, Treasury Secretary, and previous Chair of the Federal Reserve

Treasury Inflation Protected Securities (TIPS)

Treasury Inflation Protected Securities (TIPS) should not be left out of your asset allocation. The chart above shows the performance, including dividends, of VTIP. If you want low risk protection from inflation I hope this is already part of a core allocation.

Commodity Prices Have Biggest Weekly Gain since 1970s

Inflation remains a dominant consideration and the situation in Ukraine has injected a further inflation shock. The chart below shows that commodity prices have just had the biggest weekly gain since the 1970s.

US Bond Market Trend

The US bond market is now pricing in the fastest pace of inflation over the next five years going back to at least 2002.

Even as Fed Chair Powell pledges to do what he needs to do to achieve price stability, he is still operating QE balance sheet purchases and offering only a timid 25 basis point adjustment to interest rates at the March Fed meeting.

Given how late the Fed’s response has been, together with the slow speed and scale of Powell’s response, it’s reasonable to question the Fed’s commitment to keeping inflation low. While he now talks tough, what really matters is the Fed’s actions which remain unconvincing. Certainly, the quote from Yellen above is not encouraging for inflation hawks given her position as not only Treasury Secretary, but also the prior Fed Chair. Looking a little deeper into this question it seems that the incentives for government are less aligned with low inflation than you might think.

This makes it even more important that the Fed Chair acts more effectively to dispel inflation concerns. As shown above, the market is now pricing in inflation well above the Fed’s stated objective for the next 5 years.

TIPS Advantage Over Other Asset Classes

TIPS offer a two way advantage compared to other asset classes. TIPS perform well when real interest rates are falling and/or when inflation is rising. For example, if the oil price is rising strongly they benefit from rising inflation, but in addition if high oil prices induce weaker growth, as they have in the past, then real interest rates will subsequently fall even after oil has peaked. This makes TIPS a highly durable allocation and a great low risk way to play a commodity boom.

Here is the history of how oil, policy, and the economy interact:

Interestingly, the Fed’s policy process has tended to follow a predictable and recurrent pattern for over 70 years. Step one: Be too easy. Step two: that begets energy inflation, which tends to creep into broader headline inflation. Step three: the Fed then begins to tighten its policy and ultimately pricks the energy inflation bubble it created, but, in so doing has 10 for 10 times caused a recession.”

Josh Steiner, Hedgeye

The only conditions where TIPS might underperform is when inflation is falling and real interest rates are rising. In the current environment where R-star, discussed last week, is in secular decline these adverse periods have been shallow and short lived.

Long Term Investment Considerations

For long term investment it is essential to consider long term expected returns for each asset class. TIPS currently represent attractive relative real returns compared to most other asset classes, as shown in a previous insight.

The developing situation in Ukraine is hard to predict, but it is also worth noticing that historically war has been inflationary.

In summary, the current inflation predicament creates a major challenge to policy makers and investors alike. The Fed’s inflation credibility is now at stake at a time when their flexibility is highly constrained by record debt levels and rising insolvency. Both become accute problems if bond yields rise too far. Yet if they tighten policy too little, too late and too slowly they run the risk of continuing to fail to contain inflation within their stated objectives as well as credibility.

Investors should now be highly alert to excessive inflation concerns and the policy predicament. TIPS remain one of the key asset classes to help address this issue.

Best Practice is a matter of your Best Interest.

Education and a Commitment to Informed Consent is an Obligation.

Chris Belchamber is an IRMAA Certified Planner

Medicare’s IRMAA impacts every retirement plan. Learning how to mitigate it is available via IRMAA Certified Planners designation.

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