2017 First Quarter TIPS Returns
The first quarter of 2017 was surprisingly calm for both TIPS and straight Treasurys. TIPS earned an average annualized return of 1.2%, according to my calculations; while comparable maturity Treasurys earned 0.9%. This performance came against a backdrop of expectations of rising short-term interest rates, as the Fed continued on its mission to normalize the Fed Funds rate with a 25 basis point increase in March. While yields on short-term Treasurys moved higher, long-term Treasury yields were mostly unchanged during the quarter, thus causing the yield curve to flatten slightly.
Compared with 2016 fourth quarter levels, the average yield on TIPS declined from 0.24% to -0.01%. At the same time, comparable maturity Treasury yields were essentially unchanged (2.06% to 2.07%). The flat average yield for Treasurys is a little misleading because short-term Treasury yields rose by about 14 basis points, while medium-term and long-term Treasury yields eased slightly (by 2 bp and 5 bp, respectively). That modest decline in long-term yields helped boost returns on Treasurys, offsetting the modest losses on short-term Treasurys.
The driver of higher prices (and lower yields on TIPS) was the inflation adjustment. The quarter-to-quarter change in the Consumer Price Index (CPI), upon which the inflation adjustment is based, was positive at 0.46% for the quarter, matching the 2016 fourth quarter’s 0.46% gain. Consumer inflation rose in the second half of 2016 and the first quarter of 2017, primarily because of the rebound in oil and natural gas prices during most of 2016. A 0.46% quarterly gain still translates into an annualized inflation rate of only 1.87%, but optimism about the prospects for the economy may have contributed to the relative attractiveness of TIPS during the quarter.
The strong performance of TIPS – specifically the drop in yields compared to flat straight Treasury yields – helped widen the spread between TIPS and Treasurys by 26 basis points to 208 basis points. That is the widest spread since the 2014 second quarter.
TIPS vs. Treasury Performance So Far in the 2017 Second Quarter.
The widening of the TIPS spread near the top of the eight year range (2009-2017) set the stage for a reversal of the gains in TIPS during the month of April and into May. With inflation hovering near 2%, investors are unlikely to bid down TIPS yields and thus widen the spread vs. Treasurys much beyond 200 basis points, especially when average TIP yields are near zero. As the first quarter progressed, oil and natural gas prices weakened, dampening the outlook for inflation. At the same time, the economic recovery is looking somewhat choppy, with declining demand for autos and slippage in the prices of other commodities.
Against this backdrop, TIPS prices fell by about 1 1/3 points on average from March 31 to May 9, compared with a 3/4 point gain in the first quarter. The average yield on TIPS has risen by 32 basis points to 0.32% and the spread between TIPS and Treasurys has fallen 28 basis points to about 180 basis points so far in the second quarter.
This weak performance by TIPS could be temporary, if economic growth remains less than robust and inflation remains near 2%. Recent statements by the FOMC and Fed officials suggest that as many as three more 25 basis point hikes in the Fed Funds target range are likely during the balance of 2017. If so, returns on shorter maturity Treasurys (and TIPS) will be challenged, providing some headwinds to overall sector returns.
At the same time, however, longer-term Treasurys could remain at or near current levels, especially if the inflation outlook remains benign. Although the yield spread between 2-year and 10-year Treasurys is hovering near a post-financial crisis low of about 72 basis points, it is still above the lowest levels achieved in recent history around the time of the dot.com bubble in 2000-2001 and immediately before the financial 2008 financial crisis in 2006-2007 when spreads were slightly negative.
Longer-term yields should begin to rise at least by the time the Fed Funds rate begins to approach 2%. If economic growth does not improve by then, however, the odds of an inverted yield curve would rise. It is difficult to predict how TIPS will perform in that case (both absolutely and vs. Treasurys), because performance may be affected by other factors, such as inflation, the value of the dollar, commodity prices, fiscal policy, other monetary policy choices and even geopolitical events.
May 9, 2017
Stephen P. Percoco
Lark Research, Inc.
839 Dewitt Street
Linden, New Jersey 07036
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