Exchange-traded funds linked to Treasury Inflation-Protected Securities (TIPS) rallied following the recent Federal Reserve Open Market Committee meeting. Dovish tones from Fed officials suggests the central bank is now willing to tolerate higher inflation before tightening monetary policy more aggressively.
Investors seeking exposure to TIPS may wish to consider ETFs from providers iShares, State Street Global Advisors, Deutsche Asset Management, or Vanguard.
The price of ten-year TIPS surged 1.7% following the release of details of the meeting, pushing the yield to a one-year low of 0.26%. The $16.2bn iShares TIPS Bond ETF (NYSE Arca: TIP), which tracks a range of inflation-protected US government bonds across the maturity spectrum, enjoyed its strongest weekly rally since March 2015.
The decision to revise medium-term policy forecasts comes at a time when inflationary indicators in the US have actually been rising.
David Absolon, Investment Director at Heartwood Investment Management, a London-based wealth manager, said in a statement: “While disinflationary energy effects continue to contain US headline inflation, core inflation has been drifting higher over recent months, with the latest reading at 2.3% year-on-year in February. Admittedly, base effects are contributing to stronger numbers on an annualised basis, but nevertheless a number of factors are coming together which potentially create the conditions for stronger consumer spending and, ultimately, inflation…
“…Moreover, consumer confidence indicators continue to stand at healthy levels – US consumers have not yet signed up to fears of a US recession. All in all, we expect the wealth effects of lower energy costs, low inflation and low interest rates to support consumption ahead.”
Traditionally, the role of the Fed’s open market actions has been to contain inflation and analyst consensus before the meeting predicted no interest rate increase. However, the market was taken by surprise over the Fed’s revision of its predicted number of interest rate increases this year from four to two and its paring back of forecasts for 2017 and 2018. It consequently saw investors shift their expectations for medium- to long-term inflation in the US.
So-called “break-even rates”, a gauge of expected inflation derived from comparing the yields of conventional and inflation-proof Treasuries, jumped this month, and climbed even higher following the announcement.
The ten-year break-even rate (the spread between TIPS and conventional Treasuries – a decent gauge of investors’ inflationary expectations) rose to 1.62% following the announcement, its highest level since December 2015. The five-year rate rose to 1.52% and the two-year spread reached 1.64% — the highest since July 2014.
“We believe the latest Fed commentary tells us that policymakers seem prepared to fall behind the bond market’s pricing of future inflation and interest rate expectations,” said Absolon. “In our view, this strategy of potentially allowing US inflation to run above the medium-term target of 2% as a mechanism to counterbalance global disinflationary forces is not without risk. Fed policymakers are no doubt conscious that their counterparts in the European Central Bank and Bank of Japan are burrowing down the rabbit hole of negative interest rates. In consequence, the Fed will not want to appear too aggressive in widening the interest rate differential with other markets, thus posing more US economic risks.
“In the short term, we expect the accommodative stance of central banks to continue in light of global growth and financial market developments… All that said, the inflation question is unlikely to disappear, particularly if core inflation continues to drift higher. At some point, markets may have to reassess their view of longer-term inflation expectations, whereupon again we are likely to see a return to more volatile times.”
Investors seeking exposure to TIPS through the low cost structure of an ETF may wish to consider:
The iShares $ TIPS UCITS ETF (ITPS) tracks the performance of the Barclays US Government Inflation-Linked Bond Index. The fund invests in TIPS from across the maturity spectrum, resulting in an effective duration of 8.3 years as of 18 March 2016. A total expense ratio of 0.25% applies.
The SPDR Barclays US TIPS UCITS ETF (UTIP) also tracks the performance of the Barclays US Government Inflation-Linked Bond Index. As of 18 March 2016, the effective duration is 5.0 years. A total expense ratio of 0.17% applies.
The db x-trackers II iBoxx $ Treasuries Inflation-Linked UCITS ETF (DR) (XUIT) tracks the performance of the Markit iBoxx TIPS Inflation-Linked Total Return Index. An all-in fee of 0.20% applies.
The Vanguard Short-Term Inflation-Protected Securities ETF (VTIP) tracks the performance of the Barclays US Treasury Inflation-Protected Securities (TIPS) 0–5 Year Index. As of 18 March 2016, the average duration is 2.5 years. A total expense ratio of 0.08% applies.