The Questionable Premise of the TIPS Market

Since the height of the sovereign debt turmoil that rocked Europe in mid-May, inflation-indexed Treasury securities (TIPS) have underperformed nominal Treasuries by a wide margin. As a result, the yield spread between the latter and TIPS for 10-year maturities (breakeven) has narrowed by about 50 basis points from its average (and close to its normal trend) of 230 basis points in the first four months of the year.



Source: Federal Reserve Board

The reason for the significant concession that the TIPS market has offered in the last eight weeks is a fairly straightforward one. The fiscal crunch that is affecting many European countries (including the non-eurozone U.K) has been widely perceived as a major headwind that is likely to affect adversely the growth prospects in the U.S. over the medium-term. As a result, the already unimpressive growth trajectory of the economic recovery is being downgraded, as is the already tame inflation outlook.

With core CPI already below 1.0% (0.9% year-on-year) and overall inflation steadily drifting lower (currently at 2.0% year-on-year), the expectation is that the renewed weakness in the economic outlook is likely to cause a further downward drift in both inflation measures ahead- with the behavior of the overall CPI being the relevant index for the pricing of TIPS. The term "disinflation" has increased in popular use recently, while, talk of a double-dip recession and an outright deflation has resurfaced more pointedly. Against that background, the primary appeal of TIPS (that is, to offer protection against inflation over the maturity of the security) naturally dissipates, which accounts for the narrowing of the breakevens.

Although there is little doubt that the recovery has experienced a modest loss of momentum in the last couple of months, the risks ahead have been somewhat exaggerated. The fiscal situation in Europe is already being addressed with reasonably credible measures, and, in any event, any moderation in growth there (still not a foregone conclusion, given the latest data coming out of Germany that suggest that growth is the biggest eurozone economy is still moving forward) is offset by a solid rebound in the emerging market economies. Furthermore, economic recoveries- particularly of the relatively halting kind, like the one in the U.S currently- are known for hitting an occasional soft patch, which is not in and of itself alarming. Lastly, the notion that an economic recovery will just roll over and fizzle, triggering a double-dip, has been generally not supported by history (see, http://economistscorner.blogspot.com/2009/09/do-double-dip-recessions-really-happen_09.html)

On some level, the premise upon which TIPS have underperformed Treasuries recently is almost undesrtandable, but, nonetheless, likely flawed. Although the narrowing of the bearkevens may, in view of an upcoming 30-year TIPS auction next month and the possibility of more softness in the economic data over the near-term, persist for a while longer, it remains particularly vulnerable to evidence that, all things considered, the U.S. economic recovery remains largely on track. Therefore, a trading bet on the restoration of more normal breakeven levels in the 10-year sector over the next few months merits consideration.

Anthony Karydakis