Head - Fixed Income Strategy
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Nosediving inflation expectations have hit the market for inflation-protected bonds. But we see a potential long-term opportunity.
With markets focused more on equity, credit, and interest rate volatility, inflation expectations have also taken a nosedive. Using the US Treasury Inflation Protected Securities (TIPS) market as a gauge, inflation expectations in the US have fallen to their lowest levels since the Global Financial Crisis. 10-year inflation breakeven spreads, which is the difference between nominal US Treasury (UST) yields and TIPS yields, has now dropped below 1.0%.
Anticipating the impact to CPI, investors fled the TIPS asset class severely, with the market losing over 3%. Unfortunately, we came into this sell-off with an overweight in TIPS. Trade protectionism, easy monetary policy and relatively cheap valuations left us comfortable with this view. We are inclined to keep our overweight in US TIPS. The collapse in inflation breakeven spreads and decline in real yields has been sharp and already implies a weak economic outlook, in our view. While we should not rely on a similar outcome, the 12-month return in US TIPS following the 2008 collapse in real yields was nearly 15%, or 1700 basis points better than nominal UST bonds. At the same time, if US yields reprice higher due to overly exaggerated virus fears, TIPS are also in a position to perform better than nominal UST.
For now, it seems oil prices will remain weak and volatile. This can make trading the TIPS market over the near-term quite challenging. Tactically, we would point out that oil price fluctuations can have greater impact on shorter duration TIPS, while rate volatility can have a larger impact on longer-dated bonds. However, for long-term fixed-income investors, we think current valuations in the TIPS market presents an interesting opportunity.