Not so well, it turns out, slammed by a decade of lower-than-expected inflation.
By David Enna, Tipswatch.com
Today we will take a look at CUSIP 912828QV5, a 10-year Treasury Inflation-Protected Security that originated on July 15, 2011, with a real yield to maturity of 0.639%. It matured on July 15, 2021. The question: How did it do as an investment, versus a nominal 10-year Treasury note?
I’ve been tracking the performance of every maturing 5- and 10-year TIPS on my Tips vs. Nominals page, and for much of the last decade-plus, TIPS have been a fairly lousy investment, at least versus a nominal Treasury of the same term. The reason: Inflation expectations at the time of issue ended up being higher than actual inflation over the term of the TIPS. When inflation lags expectations, TIPS perform poorly.
Back on July 11, 2011, CUSIP 912828QV5 auctioned with a real yield of 0.639% and a coupon rate of 0.625%, terms that look super appealing today. Yet it’s hard to believe that 0.639% was the second lowest 10-year TIPS auction result in history, up to that point. In July 2011, we were just entering a decade-plus era of Federal Reserve intervention in the bond markets. Just six months later, in January 2012, a new 10-year TIPS auctioned with a real yield of -0.046%, the first of nine straight auctions of this term with a negative real yield.
The key factor in judging the performance of a TIPS versus a nominal Treasury is the inflation breakeven rate, the spread between the real yield of a TIPS and the nominal yield of a Treasury. That spread represents a prediction from investors about future inflation. Unfortunately, this prediction is almost always wrong, too high or too low. And for the last decade, investors have been betting on higher inflation than actually resulted.
Here are the data for maturing 10-year TIPS:
Although CUSIP 912828QV5 had an appealing real yield of 0.639%, on the day of the auction the 10-year Treasury note was yielding 3.03%, creating an inflation breakeven rate of 2.39%, rather high for that period. Ten years later, inflation had averaged just 1.8%, meaning that the TIPS under-performed the nominal Treasury by 0.59% a year.
Investors in this TIPS ended up missing out on a strong month for inflation, because inflation accruals for a TIPS are set by inflation two months prior to the accrual. So, this TIPS did not get a bump from a 0.93% increase in non-seasonally-adjusted inflation in June 2021. If June had counted, the annual inflation rate would have risen to 1.9% and the variance would have dropped to -0.49%.
Some thoughts and qualifications
We just completed a decade-long period of inflation running at less than 2.0%. In general TIPS out-perform nominal Treasurys when the inflation-breakeven rate drops below 2.0%, especially for 10-year TIPS. But the next decade could be entirely different. Never predict the future decade based on the performance of the past decade.
Also, this chart is an estimate of performance, because it uses a full month of inflation in the ending month, when actually TIPS accruals are based on a half month for the first and last months, with the origination and maturity occurring on the 15th of the month.
Keep in mind that interest on a nominal Treasury and the TIPS coupon rate is paid out as current-year income and not reinvested. So in the case of a nominal Treasury, the interest earned could be reinvested elsewhere, which would potentially boost the gain. For certain, we don’t know what the investor could have earned precisely on an investment after re-investments.
In the case of a TIPS, the inflation adjustment compounds over time, and that will give TIPS a slight boost in return that isn’t reflected in the “average inflation” numbers presented in the chart.
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David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he discusses can purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.
The U.S. Treasury’s auction today of $16 billion in a new 10-year Treasury Inflation-Protected Security resulted in a real yield to maturity of -1.016%, the lowest in history for any TIPS auction with a 9- to 10-year term.
This is CUSIP 91282CCM1, and it was assigned a coupon rate of 0.125%, the lowest the Treasury will go for any TIPS.
A TIPS is an investment that pays a coupon rate well below that of other Treasury investments of the same term. But with a TIPS, the principal balance adjusts each month (usually up, but sometimes down) to match the current U.S. inflation rate. So the “real yield to maturity” of a TIPS indicates how much an investor will earn above (or in this case, below) inflation.
In the case of CUSIP 91282CCM1, investors were willing to accept a real yield that will lag official U.S. inflation by 1.016% a year for 10 years. Why would they do that? Two reasons: 1) because a TIPS offers protection against unexpectedly high future inflation, and 2) the yield of a nominal 10-year Treasury — currently at 1.25% — is also highly likely to lag inflation, but with no upside potential. For many investors, a TIPS looks like the better option.
Investors at Thursday’s auction had to pay a steep premium price to collect that coupon rate of 0.125%, plus future inflation accruals. The adjusted price for this TIPS was about $112.42 for about $100.44 of value, after accrued inflation and interest are added in. This TIPS will have an inflation index of 1.00387 on the settlement date of July 30.
The auction appears to have gone off without a hitch. The real yield was a bit lower than the Treasury’s yield estimate of -0.98% at the market close Wednesday. But at 12:30 p.m., the most recent 10-year TIPS trading on the secondary market was yielding -1.03%. So -1.016% looks like a reasonable result. The auction’s bid-to-cover ratio was 2.5, a solid if not stellar number.
Here is the year-to-date trend in 10-year real yields, showing the recent dip in yields as the delta variant of COVID-19 raises fears of a future economic slowdown:
This recent dip, however, is remarkable because it has followed the Federal Reserve’s June 16 “talking about talking about” meeting that should be setting a course toward tapering of its aggressive bond-buying program. When that bond buying ends — if it ever ends — both nominal and real yields are almost certain to rise.
Inflation breakeven rate
The one oddity of this auction is a dip the 10-year inflation breakeven rate for this TIPS, which came in at 2.27%, a bit below recent auctions of this term. The breakeven rate is determined by subtracting the real yield of this TIPS (-1.016%) from the current nominal yield of a 10-year Treasury (1.25%). The result is 2.27%. It means that this TIPS will outperform its nominal counterpart if inflation averages more than 2.27% over the next 10 years.
While 2.27% is high by historical standards, it seems reasonable given recent trends, with official U.S. inflation running at an annual rate of 5.4% as of June. So it is interesting to see that inflation expectations are now beginning to ease.
Here is the trend in the 10-year inflation breakeven rate for 2021 year to date:
Reaction to the auction
The TIPS ETF — which holds the full range of TIPS maturities — had been trading slightly higher all morning, indicating slightly lower yields. After the auction’s close at 1 p.m., the ETF ticked up, slightly. Not much to see here. This auction went off as expected.
Investors at today’s auction probably had to hold their noses to accept a record-low real yield for auctions of this term. However, the slight decline in the inflation breakeven rate reinforces the advantage of a TIPS over a nominal Treasury of the same term. Who wants to accept 1.25% for 10 years?
This TIPS will be reopened at auctions in September and November. It will be interesting to watch the trend in real yields through the end of the year.
Here’s a history of recent auctions of the 9- to 10-year term, dating back to January 2020. Note that today’s auction was the 8th in a row to get a negative real yield:
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David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he discusses can purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.
(And here’s the esoteric and confusing way that is calculated)
By David Enna, Tipswatch.com
Inflation trends through June 2021 make it look likely that next year’s cost-of-living adjustment for Social Security beneficiaries could fall into a range of 5.8% to 6.2% for 2022, the highest increase since a 7.4% bump in 1982. But if inflation continues at its current torrid pace, the COLA could be even higher.
The Social Security Administration’s COLA formula is ridiculously complex and little understood. Is it related to U.S. inflation? Yes, but not the inflation index you hear about each month. Does it reflect 12 months of U.S. inflation? Not really. Does it underestimate actual U.S. inflation? Most years, yes.
U.S. inflation (measured by CPI-U) is running at 5.4% as of June, but the Social Security Administration doesn’t use CPI-U. Instead, it uses the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). For that index, the June annual increase was actually higher, at 6.1%.
You are going to see that number — 6.1% — used often as the projection for the Social Security COLA in 2022. It is the current estimate of the Senior Citizen’s League, a credible advocacy group. It looks to me to be a reasonable projection, but at this point, the COLA’s complex formula makes things iffy. Let’s take a look at how the COLA comes together …
The Index
CPI-W includes data only from households with at least 50% of income coming from clerical or wage-paying jobs. I’ve noted in the past that CPI-W generally lags slightly behind CPI-U, which means the Social Security COLA also generally lags behind the standard measure of U.S. inflation. This year, at least through June, it is running higher than official inflation.
CPI-W isn’t widely tracked or reported, but the Bureau of Labor Statistics updates the index each month in its overall inflation report. Right now, you could say, “Well, CPI-W is running at an annual rate of 6.1%, so that will likely be the COLA increase for 2020.” But that’s not true. In fact, the June number isn’t necessarily an accurate indicator, as shown in this chart:
June sets the baseline for the COLA increase, but then we come to …
The Formula
The SSA doesn’t look at a full year’s data to determine the COLA. Instead it uses the average CPI-W index for the third quarter — July, August and September. Here is the language from the SSA site:
A COLA effective for December of the current year is equal to the percentage increase (if any) in the average CPI-W for the third quarter of the current year over the average for the third quarter of the last year in which a COLA became effective. If there is an increase, it must be rounded to the nearest tenth of one percent. If there is no increase, or if the rounded increase is zero, there is no COLA.
This wording means that the SSA eliminates years where inflation was zero or negative, and so there isn’t a “bounce-up” effect on benefits after a year of deflation. Instead, it goes back to the last year where there was an increase in benefits. But that won’t matter in this 2022 calculation, because the COLA rose 1.3% last year.
So, although 12-month CPI-W was up 6.1% in June, that number is only the baseline for the 2022 COLA increase. The only inflation numbers that will matter are for the third quarter: July, August and September. Last year, the CPI-W index averaged 253.412 in the third quarter. The June 2021 index was set at 266.412, or 5.1% higher than that average. So if we have zero inflation in the third quarter of 2021, the Social Security COLA be set at 5.1%.
U.S. inflation can be stubbornly finicky in the summer months, so predicting inflation from July to September is an impossible task. Hurricanes, gas shortages, food crop failures, stock market plunges, supply shortages, pandemic resurgence, etc., etc. It’s a guessing game, and nearly every summer brings some surprises.
Projecting the 2022 COLA
At this point, CPI-W is running at 6.1% over the last year, so you’d expect a continued inflationary trend of about 0.5% a month in July, August or September. But what if inflation dips after the multi-month surge so far in 2021? Could it run at 0.0% for three months? Doesn’t seem likely. But what about 0.4% a month? That seems possible.
Let’s take a look at how differences in 3rd-quarter inflation would alter the 2022 COLA:
My thinking is that after months of red-hot U.S. inflation, we could see things cool off a bit this summer. Used car prices aren’t likely to continue surging at a 45% annual pace, for example. Even air fares and hotel costs could slip if pandemic fears keep brewing. But other effects — gasoline and food costs, for example, and a possible spending surge caused by the new child care tax credit — could keep inflation rising a brisk pace.
Another factor is that CPI-W had a mild surge last summer, rising 0.6% in July and then 0.4% in August and 0.2% in September. That will make those numbers a bit harder to top than the June 2020 index, which was up 6.1% in June 2021.
So, if you think that CPI-W inflation will rise on average 0.3% a month in the 3rd quarter, you’d end up with a 5.8% COLA increase in 2022. If the average rises to 0.4%, the COLA would be 6.0% and if it rises to 0.5%, 6.2%. I think those are the most likely results, as I have shown in the chart.
That leads me to project that the 2022 Social Security COLA will fall into a range of 5.8% to 6.2%, and so let’s just go with 6.0% as most likely number.
Where can this go wrong? The stock market was taking a pummeling today, and two things also happened: Crude oil prices dipped sharply (down more than 7% today) and the U.S. dollar is getting stronger (up about 1.2% in the last month). Lower oil prices and a stronger dollar could dampen inflation over the next few months. Summer = market volatility.
What this means for Social Security recipients
The Social Security Administration currently estimates that the average retired beneficiary receives $1,555.25 a month, so a 6% increase would boost that monthly payment to about $1,648.56, an increase of $93.31 a month. If you are in the Social Security “limbo” period — older than 62 but not yet taking benefits — your future benefits would also climb by this percentage.
However, recipients can also expect that Medicare Part B costs will rise in 2022, which will subtract — at least partly — from the higher benefits. The base premium is now $148.50 a month. I could see that rising to $158 a month, cutting the effect of the COLA increase by $9.50 a month. But this is just speculation.
We won’t know the actual COLA number until 8:30 a.m. EDT on October 13, 2021, when the Bureau of Labor Statistics releases the September inflation report and completes the data needed for the 3rd quarter average of CPI-W. I will be tracking these numbers for July, August and September as each inflation report is issued.
One more thing. One interesting side issue is that a 6% increase in benefits in 2022 could speed up Social Security’s path toward depleting its “trust fund” of accumulated payroll taxes. Once that happens, possibly in the early 2030s, Social Security will need to rely on incoming payroll taxes, which could cover only about 75% of projected benefits. Congress could — and should — address this issue quickly by gradually raising the full retirement age, or raising the income cap on payroll taxes, or taxing 100% — instead of 85% — of Social Security benefits for wealthy beneficiaries. Or some combination. We’ll see.
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David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he discusses can purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.
Hint: It won’t be a thing of beauty. But investors may snatch it up.
By David Enna, Tipswatch.com
The U.S. Treasury on Thursday will offer $16 billion in a new 10-year Treasury Inflation-Protected Security, CUSIP 91282CCM1. The coupon rate and real yield to maturity will be determined by the auction result.
A TIPS is an investment that pays a coupon rate well below that of other Treasury investments of the same term. But with a TIPS, the principal balance adjusts each month (usually up, but sometimes down) to match the current U.S. inflation rate. So the “real yield to maturity” of a TIPS indicates how much an investor will earn above (or in this case, below) inflation.
This is a new TIPS, and auction results for new issues can be a little more complicated to predict. After all, there will be $16 billion in new supply entering the market. And these TIPS auction amounts have been inching higher as the Treasury requires more borrowing to finance ever-larger U.S. deficits. Here are auction amounts for recent new 10-year issues:
July 22, 2021: $16 billion
Jan. 21, 2021: $15 billion
July 23, 2020: $14 billion
Jan. 23, 2020: $14 billion
July 18, 2019: $14 billion
Jan. 17, 2019: $13 billion
In less than three years, the 10-year auction amounts have increased 23%. At some point, will the offering size grow too large for demand? That’s not likely for now, as the Federal Reserve continues aggressively buying TIPS and other U.S. Treasurys, keeping yields under control.
One thing about Thursday’s auction is certain: The Treasury will set the coupon rate for this TIPS at 0.125%, the lowest it will go for any TIPS.
As of Friday’s market close, the Treasury, on its Real Yields Curve page, was estimating that a full-term 10-year TIPS would have a real yield of -1.02%. That estimate has dropped 15 basis points since July 1. So the yield trend is working against potential investors in this TIPS. And that deeply negative yield — much lower than the coupon rate of 0.125% — will make this TIPS pricey. The adjusted auction price will probably be about $112 for about $100.39 of value, after accrued inflation is added in.
This TIPS will have an inflation index of 1.00387 on the settlement date of July 30. That number, by the way, is a reflection of the extraordinarily high non-seasonally adjusted inflation of 0.80% in May 2021. One month later, in August, the principal balance of this TIPS will adjust 0.93% higher, matching non-seasonally adjusted inflation in June. This two-month inflation trend definitely adds to the appeal of this TIPS.
If CUSIP 91282CCM1 does auction with a real yield to maturity of -1.02%, it will be the lowest yield ever for any 9- to 10-year TIPS auction. The current record low of -0.987% was set in a January 2021 auction.
Here is the trend in 10-year real yields over the last five years, showing the deep decline in the period after March 2020, when the COVID-19 pandemic began exploding across the United States. In mid-March, the Federal Reserve began an aggressive program of bond-buying, which has kept both real and nominal yields at extremely low levels.
Inflation breakeven rate
The Treasury is currently estimating the nominal yield of a full-term 10-year Treasury note at 1.31%, which means that if CUSIP 91282CCM1 auctions with a yield of -1.02%, it will get an inflation breakeven rate of 2.33%. That is well off recent highs for this metric, which hit a one-year high of 2.54% on May 17.
A lower inflation breakeven rate makes this TIPS more attractive versus its nominal alternative, and that should increase investor demand for this offering. It’s just a mathematical calculation. At current yields, this TIPS would greatly outperform a nominal Treasury if official U.S. inflation continues at 3% or higher. Here are the numbers:
Of course, this TIPS would also be a loser if inflation doesn’t maintain at an average of 2.33% for 10 years. Over the last 10 years, inflation has averaged 1.9%, so the market is pricing in higher-than-usual inflation over the next 10 years. My conclusion: I am not at all interested in a nominal 10-year Treasury yielding 1.31%. This new TIPS is at least a bit more intriguing, even if it gets a record low real yield.
Here is the trend in the 10-year inflation breakeven rate over the last five years, showing the lofty surge higher after March 2020, when both the Federal Reserve and Congress launched aggressive economic stimulus programs:
I Bonds remain the better alternative
I always feel the need to mention that U.S. Series I Savings Bonds, which currently can be bought with a permanent fixed rate of 0.0%, are a much better investment than a 10-year TIPS with a real yield of -1.02%. The I Bond has a 102-basis-point yield advantage, earns tax-deferred interest and has much better protection against deflation.
I Bonds have a purchase limit of $10,000 per person per calendar year. So if you are interested in inflation protection, I recommend purchasing I Bonds first, up to the limit, and then consider an investment in a Treasury Inflation-Protected Security.
For investors with a longer investment horizon, EE Bonds are also very attractive in our low-rate environment. They have a fixed rate of 0.1%, but will double in value if held for 20 years, giving them a return of 3.5%. But they have to be held 20 years. If that is reasonable for you, they are a strong investment today. A 20-year nominal Treasury is yielding 1.86%, so the EE Bond has a yield advantage of 164 basis points. EE Bonds also have a separate purchase cap of $10,000 per person per calendar year.
Conclusion
I probably won’t be an investor in this new 10-year TIPS, but I will be watching the Treasury’s Real Yields Curve page to see if yields are surging higher. I can see the appeal for an investor who believes real and nominal yields aren’t likely to rise dramtically in the mid-term future. In fact, if you believe real yields are heading even lower, this TIPS is an attractive investment.
I will be reporting the results soon after the auction closes at 1 p.m. Thursday. Non-competitive bids have to be made before noon.
Here is a history of recent TIPS auctions of this term:
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David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he discusses can purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.
You don’t seriously think I have answers, right? Just some ideas.
By David Enna, Tipswatch.com
What the heck was I thinking? A couple weeks ago, I started on a trek to review Federal Reserve actions and bond market reactions for the period of 2013 to 2021. My theory was that in July 2021, we are sitting on the edge of change, just as we were in June 2013, when the Federal Reserve “announced” it was “planning” to cut back on quantitative easing, its aggressive bond buying program.
Back in mid-June I created this chart for a similar article looking toward future Fed actions. I think it is remarkable how close real yields were in December 2012 to those of mid-June 2021. The surge higher in 2013, which was very strong, only took about 10 months, and it made the 2013 the worst year for bond funds in the last 10 years.
I thought it would be worth taking a year-by-year look at how my three favorite bond ETFs — Vanguard Short-Term Inflation Protected (VTIP), Schwab U.S. TIPS (SCHP) and Vanguard’s Total Bond (BND) — performed during this time of financial change. These are three conservative, liquid, mainstream bond funds with very low expense ratios. Here’s a recap of their basic statistics and performance.
Shifting focus back to 2013, it’s important to stress that the Federal Reserve didn’t actually do anything in that year. Because of ensuing market turmoil, the Fed delayed tapering of bond buying until January 2014. Nevertheless, 2013 was a disastrous year for the bond market, with a “taper tantrum” causing both real and nominal yields to soar 100 basis points or more. Is that where we are heading in 2021, now that the Federal Reserve has announced it is “talking about talking about” tapering its current bond-buying stimulus?
So far, at least, the financial markets don’t think so.
2021: So far, so good
In the first half of 2021, as the COVID-19 pandemic slowly wound down, financial markets took a breather. Bond yields were up, but not dramatically. The stock market was up — strongly — with the S&P 500 registering a total return of 17.8% in 2021, through June 30. Inflation is also surging, hitting an annual rate of 5.4% in June, the highest rate in 13 years.
The one nagging point came June 14, when Federal Reserve Chairman Jerome Powell said this at a news conference:
“But you can think of this meeting that we had as the talking about talking about meeting, if you like. And I now suggest that we retire that term, which has served its purpose well, I think.”
Powell said, in essence, that the Fed is now willing to talk about future tapering of its aggressive program of buying U.S. Treasurys and mortgage-based securities in support of the U.S. economy. We don’t know when the bond buying will end, or how quickly it will end, but it is now on the table. In addition, increases in short term interest rates could begin in late 2022 or 2023, a year earlier than had been expected.
That one statement should have been enough to set off at least a mini “taper tantrum,” but after a day or two of market unrest, the financial markets continued in happy bliss, with the yield on a 10-year nominal Treasury dipping 9 basis points in the month after Powell’s statement.
It is clear that the markets don’t believe any tapering of the Fed’s bond buying is likely in the near future, and that any increases in short-term interest rates are at least 18 months away. And the markets are probably right. Powell’s statement on June 14 was the first step in a months-long campaign to prepare the markets for the eventual tapering and then end to the bond-buying program.
One thing I have learned in this nine-article review of Fed history is that the Fed is very slow to reverse “easing” financial actions, and very quick in reversing “tightening.” So in 2021 we have entered at holding pattern, with inflation and the stock market surging, and the bond markets remaining relatively calm, so far. Here is a snapshot of the bond market in 2021:
Notice that real yields have been rising at a slower pace than nominal yields, which indicates the market is pricing in higher inflation expectations. Rightly so, since annual U.S. inflation has surged from 1.4% in January to 5.4% in June. In this scenario, you can expect TIPS funds to outperform nominal funds of similar duration.
Here is how our three bond ETFs performed in the first half of 2021, with the chart showing net asset value and not including distributions:
Vanguard’s VTIP fund, with its lower duration and gains from the inflationary surge, has been the top performer, despite the higher real yields. Schwab’s U.S. TIPS ETF has also performed well, aided by inflation accruals. The total bond market, BND, has lagged because its underlying nominal rates can’t overcome the effects of higher nominal rates.
All in all, though, 2021 has been a ho-hum year in the U.S. bond market. Will that continue? Well ….
Beyond 2021: Where are we heading?
OK, now we begin the pure speculation portion of this article. I can only describe my “gut feelings,” which tend to be right about as often as they are wrong. What is ahead? This speculation is based on the pandemic fading away and the U.S. economy avoiding any serious financial shocks.
The Fed will begin tapering its bond buying. If inflation continues to surge higher, remaining well above 5%, I’d guess this could happen in 2021, but more likely it will be early 2022. If the economy remains stable, bond-buying should end six months later. But the Fed will continue to hold a huge supply of U.S. Treasurys and mortgage-backed securities.
Here is a look at how the Federal Reserve has increased its total assets from 2013 to June 2021, showing how dramatically larger the 2020 bond-buying program has been versus the pre-2013 purchases, which continued through December 2014:
Investors should recognize, and the Fed would readily admit, that the Federal Reserve is manipulating the U.S. Treasury market. For example, examine the New York Fed’s purchase plans for the period of June 14 to July 14, 2021. In that time, the Fed planned to purchase $2.4 billion of 7.5- to 30-year TIPS and $2.0 billion of 1- to 7.5-year TIPS. That’s a total of $4.4 billion for the month, equal to about one-quarter of the value of the reopened 5-year TIPS auctioned in June. This happens month after month, and may actually under-estimate the Fed’s holdings because of reinvestments.
Tapering of Federal Reserve bond purchases is a huge deal.
The Fed won’t raise short-term interest rates until late 2023. In 2014, the Federal Reserve officially started tapering its bond-buying stimulus in January and ended the bond buying in October 2014. It didn’t raise short-term interest rates above zero until December 2015, 15 months later. So if this pattern continues, rate increases won’t follow quickly after the end of bond-buying stimulus. Expect the Fed to send mixed signals the whole way, but as the rate increase cycle nears, the Fed will give clear signals it is coming.
The yield curve will flatten once short-term rates begin rising. This is sort of a self-fulfilling prophecy. The end of quantitative easing should cause longer-term yields to rise, expanding the yield curve. But when short-term rates begin rising, the market can lose confidence in economic conditions. So, short-term rates (controlled by the Fed) will begin rising and longer-term rates (controlled by the markets) will begin falling. This ends up supporting the bond market through the early rate hikes.
Inflation will run higher than 2.5% a year in the mid-term future. The Fed will be highly unlikely to take any tightening action if inflation cannot sustain above 2.5%. So, expect inflation to sustain at that level.
Eventually, the 10-year real yield should “normalize” to a range of about 0.75% and the 10-year nominal yield could climb to 3% or higher. Maybe this is wishful thinking. But I do think we will again see these yields in the mid-term future. Less than three years ago, in November 2018, a 10-year TIPS reopening auction got a real yield to maturity of 1.109%. Around the same time, the 10-year nominal Treasury was yielding 3.01%.
The stock market will take a hit along the way. But it won’t necessarily be a disaster. The Federal Reserve has a history of backing up the stock market, acting quickly to intervene at times when stock prices are plummeting. That isn’t going to change. However, the highest-flying, speculative stocks could take a beating if the 10-year nominal Treasury reaches 3% or higher. That opens the door to the “risk off” trade and could bleed money out of the stock market.
However, the market in recent weeks has shown that it does not have any belief that the Federal Reserve will carry through with an end to the bond-buying, forcing the 10-year Treasury yield down to 1.25% recently. From a Market Watch report:
“Traders don’t see the Fed repeating the 2015-2018 hiking cycle, which brought the policy rate band to 2.25%-2.50% in December 2018, and a peak 10 year rate of 3.2% in November 2018, said the strategists. …
“Bank of America doesn’t see a sharp rise in rates such as was seen in the first quarter — driven by positive vaccine surprises and fiscal stimulus — but they see scope for modestly higher rates in the next six to 12 months. “We have not changed our forecast for 10y rates at 1.9% by year-end, but downside risks to our forecast have increased,” (BofA’s Ralph Axel) said.
Selecting the right bond ETF? Don’t even try.
The one thing the 2013 to 2021 era has proven is that there isn’t one “correct answer” when choosing a bond fund. My personal preference is intermediate-term TIPS, combined with Treasury or Treasury-dominated funds with very low expense ratios. Here is a recap of how our three bond ETFs performed through those years, with the addition of the S&P 500 ETF (SPY) and notes on Federal Reserve actions in each of those years:
First of all, please take note of the stock market’s performance during this time of financial turmoil — up 32% in total return in 2013, up 21% in 2017, up 31% in 2019, up 18% in 2020 and up 17% for the first half of 2021. There was only one year — 2018 — when the stock market had a negative total return, and that was only -4.56%. The Federal Reserve’s policies during this period were “very kind” to the stock market, even during periods of tightening. A future period of rising interest rates shouldn’t send the stock market crashing down. (However, high valuations are another matter … )
For the bond funds, I’ve noted the top performer of the three ETFs for each year. VTIP was at the top 3 years, SCHP two years and BND four years. I’d suggest investing in a combination of the three funds: VTIP for the combination of shorter duration and inflation protection, SCHP for longer duration and inflation protection, and BND as an attractive “core” nominal bond fund with very low expenses and an intermediate duration.
Another alternative: Get your inflation protection by buying individual TIPS and U.S. Series I Bonds, and then use BND for your nominal bond allocation. By buying TIPS and holding them to maturity, you can ignore the market swings up and down. But you also lose the chance for a capital gain if real yields decline.
One final conclusion
I am the founder of a website devoted to inflation and inflation protection, and so I definitely have a bias. I am a believer in devoting a portion of your asset allocation to inflation protection. Over the last 10 years, than has been a “losing” philosophy, with inflation lagging well below expectations during that decade. Today, inflation is much higher than expectations.
I don’t know where inflation is heading. I don’t think the Federal Reserve can say where it is heading with much confidence, either. For people in retirement, inflation can be devastating. TIPS and I Bonds provide some reassurance, even if their performance can be underwhelming.
Inflation protection helps me sleep at night. But that’s just me, and this ends my “speculation” on the future.
Coming soon: I’ll take a stab at projecting the Social Security COLA for 2022
Coming soon: Is the Treasury likely to raise the I Bond’s fixed rate in November?
David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he discusses can purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.
