Last November, most financial markets had to quickly re-calibrate to new and unexpected formulas resulting from the election landslide. The stunning rise in yield for the 10 year US Treasury bond from 1.8% to 2.6% in just a few short weeks captures the essence which is centered on the potential for nominal GDP to break on through to higher territory. This higher nominal GDP balloon was filled with the air of moving higher on both its underlying parts: higher real economic growth (real GDP) AND more inflation as more activity could finally get all this money sloshing around.
Fast forward several months and this balloon didn’t as much pop as it did find a slow but persistent leak. A sudden collapse in cell phone prices and oil suppressed by OPEC cheaters and US shale producers has played a role. But so has a reduction in the prospects for the infrastructure spending and tax cuts that led to air in the balloon in the first place. Last week’s continuation of weak inflation has cast more light on the current disinflation trends. However, I believe this is a good spot here in mid – August to take a step back and evaluate – specifically within a fixed income context. Cutting to the bottom line, this is a good spot to have exposure to Treasury Inflation Protected Securities (TIPS).
The Granddaddy of Measuring TIPS Value….The Breakeven Spread
To begin making any case either for or against TIPS, I must start with break even spreads. Break even spreads are simply a calculation that tells you how much inflation would be required to make the returns on a TIPS bond equal to that of its unprotected (and higher yielding) counterpart. The straightforward calculation is simply the difference in yield between a regular US Treasury bond and one that is of the same maturity but protected by inflation. If a regular old treasury bond yielded 2.0% and a TIPS bond yielded 0.0%, then the break even spread would be 2%. Thus, if inflation then proceeded to equal 2% over the life of the bond – the investor would “break even” by having an equal return on both bonds.
To take it a step further, we then think about the recent trends (last 5 years charted below) and how TIPS have performed compared to regular treasury by monitoring whether this spread has been moving up or down. As the spread moves up, you are better off in TIPS as it means the yield had to rise faster in nominal bonds (and prices down faster) and vice versa of course on the way down.
Failed to Break Even
TIPS have been the beets in the smorgasbord of bonds. They are certainly on the buffet as an option, but putting them on your plate has done nothing but stink it up. Like a smorgasbord, you just don’t to take one of everything. I realize this isn’t a perfect analogy since there are plenty of folks (like my 11 year old son) that love beets. But, you get my point – that for a couple of reasons TIPS just haven’t been the place to be.
The first reason is due to a drop in the pricing of the “I” part of TIPS which can be seen in the chart above shows as the break even spreads fell from a range above 2 to one well below. Again, the only way this happens is by the prices of regular bonds outpacing those of tips. Thankfully, in FEG portfolios, we began exiting a rather healthy TIPS allocation in ’12 and were fully out in early 2013. Owners of TIPS got a rather healthy and nice pop during the middle of 2016 before just exploding last November, but generally speaking; they haven’t been the place to be.
The chart below shows it more clearly with the total returns from the major types of bond ETFs over the past 5 years. Investment grade corporates (LQD) have brought home over 20% cumulatively while TIPS are bringing up the rear with barely a positive return!
This leads me to the second source of TIPS underperformance: the “T”. During relatively healthy economic and financial conditions it pays to earn the corporate spread by taking on credit risk of over just being in treasuries. Taking it one step further, it pays even more as that spread drops, meaning relative price appreciation for those owners of the bonds. This is what we’ve seen continue as of late to the point where investors have begun to compete with one another to take on corporate risk, handsomely rewarding their owners (including those in FEG portfolios)
Going Forward
Re-iterating the punchline, most of this has been a recap of the rearview mirror but as of late – TIPS have made more sense to me as of late for a couple of reasons that I will attempt to unpack. Perhaps not yet to a full blown large position, but it’s time for at least a small, diversifying way. Why? For me, it’s always about the price – the inflation outlook doesn’t have to be great, just better than suggested by the price. And I do think that’s the case here where at least a decent pitch can be made for at least some inflation. Lastly, it is the razor thin corporate spread to be earned by being in corporates over treasuries. Investors just simply don’t have enough cushions by taking on corporate risk.
Money Supply Should lead to Brighter Outlook
One thing that leads me to believe the inflation outlook should be brighter than currently given credit is going old school and simply looking at broad money supply measures. As seen on the following chart -throughout the 60’s, 70’s & 80’s – M2 (the macro econ 101 money supply measure counting cash, checking and savings accounts) steadily hovered around 55 to 60%. Just for the econ readers – I think it’s pretty safe to say we can see Milton Friedman’s hands in matching money supply to economic growth.
However, this dropped throughout the 1990’s thanks to a booming productivity and technological advances that could spread money around faster. The Greenspan-Bernanke-Yellen activist central bank regime however has been working ever so hard at taking our money supply to new heights (as a percent of the economy).
What’s this got to do with inflation? Taking the chance to mention Friedman a second time, it was he who taught us that inflation is always and everywhere a monetary phenomenon. After all, in an effort to keep it simple enough – inflation is really just about too much money chasing too few goods. It’s certainly possible this last and big leg up in the money supply could indeed lift inflation. The relatively low money supply in the mid 90’s and early ‘00s was certainly coincident with low inflation. The following chart is the same as above with M2 as a % of GDP but has an inflation overlay (set forward 5 years under the thought that it takes time in reality for things to run through the economy). Both measures are smoothed by taking a trailing 12 month average.
Using M2 is an inflation predictor is pretty far from perfect. For instance – the money supply can “go up” for odd reasons. 2008-2009 was a classic example as people were selling assets and parking money in their bank accounts which boosts m2. This isn’t money that is likely to be circulating in the economy and creating inflation. But, nothing is going to be perfect because if there were – we’d be far better at predicting it and profiting from it.
It’s easy to see at least a loose relationship (for the math junkies an R squared of about .3). I don’t know any more than the next guy if we can break free from this 2% range back to the more historic norm of 3%. Furthermore, we find scant evidence that any of the global deflationary forces (technology, excess capacity) have dissipated. The key for me though is that the market pricing for inflation respects the latter and gives virtually no probability to the former. This is why it’s a reasonable time to grab some protection / diversification through TIPS.
Another worthy criticism of M2 is that it is too narrow in an evolved financial economy for use in an analytical context. I can’t argue with that, but M4 – a measure put together by the Center for Financial Stability – can also be seen to be growing a faster clip recently.
Under the Umbrella and close to the Handle
Going back to the other factor that has kept TIPS a big underperformer has been the corporate spread and the power it has given to the outperformance of corporate bonds. However, that cushion has fallen to razor then levels – with an A rated US corporation providing only 1% more yield than a US treasury. It’s still higher compensation, but there’s also much less cushion for when we get a de-risking and much less upside as it compresses from here. While A rated corporate bonds provide you a protective umbrella, treasuries get you closer to the handle. I can’t tell you what would cause spreads to move back to a more normal level or when that would happen. I can just tell you, the margin for error is small and that it’s at least worth mentioning that the Fed has announced they will begin their Quantitative Tightening program (QT). Quantitate Easing (QE) could easily be argued as a factor to keeping spreads tight.
Conclusion
This case may not apply to every portfolio, so take it for what it’s worth and what it may mean to you. This case for TIPS is certainly meant to mean more to those that have significant fixed income exposure. Fundamentally – whether it’s here about TIPS value or elsewhere its more about the price and many have given up on TIPS. Said another way another move up on the reflationary trade may not happen (odds certainly don’t look that bright at this point), but the point is you aren’t paying that much for protection if it does. As a last thought, I think about what it would mean if M2 were to slow way down and revert back to its longer term mean as a % of the economy. If the money supply / inflation relationship were to correct this way, I would certainly worry about the appetite for things further down the risk curve like corporate bonds.
