Key Takeaways
- We have become more constructive on U.S. Treasury Inflation-Protected Securities (TIPS), primarily in maturities under three years. The sharp decline in short-term inflation breakeven rates has improved their risk/reward profile, creating a more attractive entry point by lowering the hurdle required for TIPS to outperform comparable nominal U.S. Treasuries.
- Persistent geopolitical tensions and oil-related inflation concerns have complicated hedging strategies. We believe short-dated TIPS are now better positioned to deliver some portfolio ballast against upside inflation surprises.
- Longer-dated TIPS are less compelling. Longer-dated breakevens have remained more resilient. A better tactical opportunity exists in shorter maturities where inflation risks remain elevated relative to current market pricing.
What has changed?
Earlier this year, we viewed TIPS less favorably. Inflation appeared to be moderating, and U.S. Treasury inflation breakeven rates reflected a reasonable inflation outlook. Under those conditions, the hurdle for TIPS to outperform like-maturity nominal U.S. Treasuries appeared relatively high.
That backdrop shifted following the start of the conflict in the Middle East. Rising energy prices and supply chain disruptions contributed to renewed inflation pressures and rising inflation expectations. In response, inflation breakeven rates moved higher, making it more difficult for TIPS to outperform on a relative basis. As the length of the conflict extended from weeks to months, this dynamic accelerated.
More recently, inflation breakeven rates have moved sharply lower based on tenuous progress toward the reopening of the Strait of Hormuz. Breakevens now sit below pre-conflict levels, though upside inflation risks remain elevated in the near term. This repricing reflects a market that increasingly expects tighter-for-longer monetary policy and higher real interest rates. Short-dated TIPS can help portfolios navigate the current economic environment characterized by elevated energy prices, sticky inflation data, and resilient economic activity, each of which can contribute to higher-than-anticipated Consumer Price Index (CPI) inflation data.
Why favor short maturities?
The entry point for short-dated TIPS has improved. As breakeven inflation rates fall, the realized inflation required for TIPS to outperform comparable nominal U.S. Treasuries declines as well. The 2-year TIPS yield currently implies roughly 2.1% average inflation over the next two years. All else equal, 2-year TIPS should outperform comparable nominal U.S. Treasuries if realized inflation averages above that level. For context, year-over-year CPI inflation currently sits at 3.5%.
Near-term inflation risks remain elevated. While geopolitical tensions may ultimately subside, several factors could keep inflation firmer than markets currently anticipate, including elevated energy prices and supply chain disruptions. Additionally, the U.S. economy continues to perform well, powered by strong consumers, a stable labor market, and significant AI-related investment.
Short-dated TIPS provide a more targeted hedge. Investors concerned that inflation will remain stickier than current expectations over the near term can potentially benefit from shorter-term TIPS, which offer a more direct relationship to realized inflation over the next 12 to 36 months while limiting interest rate sensitivity (i.e., duration risk).
The opportunity is less compelling in the intermediate and longer portions of the TIPS curve. Unlike the front end, 5- to 10-year breakeven inflation rates have remained less reactive over the past five months to Middle East developments, diminishing their tactical opportunity. In addition, longer-dated TIPS typically require greater tolerance for interest rate volatility, which has increased since the start of the year.
Bottom line
Lower breakeven inflation rates have improved the risk/reward profile and entry point for short-dated TIPS, namely in maturities under 3 years. They offer a targeted hedge against near-term inflation uncertainty. Additionally, like U.S. Treasury bonds, TIPS are considered high quality, backed by the full faith and credit of the United States government. Our longer-term return outlook remains constructive for core U.S. fixed income, especially given today’s elevated starting yields. Short-maturity TIPS can offer investors a complementary tool to help navigate near-term inflation uncertainty.
