Janet Yellen, the Federal Reserve chair, set off a lot of turmoil in the markets on March 19 by hinting that the federal funds rate – which sets a base for short-term interest rates – could begin rising ‘around six months, that type of thing‘ after the Fed’s bond-buying program ends later this year.
That comment, at a news conference, sent the bond and stock markets into a tizzy. Yellen’s off-the-cuff comment implied that rates could begin rising in mid 2015 instead of late 2015 early 2016, as the markets expected.
Since then, Yellen and the Fed have backed off, saying there is no timetable for increases in the federal funds rate. But the Federal Reserve itself is forecasting that its benchmark rate – now close to zero – will rise at least to 1% at the end of 2015 and to 2.25% by the end of 2016.
So let’s assume that the federal funds rate does rise to 2.25% at the end of 2016. How will that affect the prices and yields of Treasury Inflation-Protected Securities?
No surprise. Rates are going up. No one can say this for certain, of course, and it depends on three things happening: 1) the U.S. economy must continue to improve, 2) the inflation rate must reach or at least approach the target level of 2%, and 3) the Federal Reserve must have the courage to raise rates when 1 and 2 are achieved.
But if these three things happen – and this is the most likely scenario, in my opinion – we will see the federal funds rate at 2.25% at the end of 2016 (or earlier), and we will see yields rise for both nominal Treasurys and TIPS.
So let’s take a look at the history of the federal funds rate; I have included some numbers from the past in the chart at the right. If you want to see the data, check out this site. What you will find is that 2.25% is a historically low rate. Today’s ultra-low fed rate – at a time when the stock market is hitting all-time highs – looks as out of place as that 20.06% number from January 1981.
So, the point is, there would be nothing extraordinary about a 2.25% fed rate, and in fact, it historically would have been a rate meant to spur economic growth, not deter it.
My next step was to look at times when the fed rate stood at 2.25% and cross-check the then-current yields for nominal Treasurys and TIPS. Here is what I found when I did the calculations on March 27:
Yes, the data are limited for several reasons: 1) TIPS have been in existence only since 1997, 2) a federal funds rate of 2.25% is relatively rare and 3) 30-year TIPS auctions were halted from October 2011 to February 2010, so there are no comparable data for 30-year TIPS.
But using these numbers as guidelines, I think we can make predictions about where interest rates are headed (not precisely, but an estimate) when the fed funds rate reaches 2.25%. I am using the average of each range to determine these numbers:
- 5-year Treasury yields will increase 149 basis points
- 5-year TIPS yields will rise 82 basis points
- 10-year Treasury yields will rise 120 basis points
- 10-year TIPS yields will rise 97 basis points
- 30-year Treasury yields will rise 82 basis points
- 30-year TIPS yields will rise an undetermined amount
Continuing on with this premise, let’s say the 10-year TIPS yield rises 97 basis points by the end of 2016, reaching a level of 1.53%. That’s perfectly reasonable by historical standards (probably even conservative), and it would equate to a 10-year nominal Treasury rate of 3.89%, creating an inflation breakeven point of 2.36%, also perfectly reasonable.
This sort of rise – 97 basis points – is definitely possible. In fact, we saw that happen in less than three months in 2013, when the 10-year TIPS yield rose from -0.74% on April 5 to 0.29% in June 19, a rise of 103 basis points.
What does this mean? If you are invested in a diversified TIPS mutual fund and this scenario plays out, you are going to see a drop in net asset value of about 8%. At the same time, you would benefit from a higher yield in the future.
The TIP ETF, which invests in a broad range of maturities, has a duration of 7.65, meaning its net asset value should decline by 7.65% when yields rise 100 basis points. That played out just as predicted during the 103 basis point rise in the 10-year TIPS from April 5, 2013 to June 19, 2013:
Looking into the future. The TIP ETF currently trades at $111.67, up about 1% so far this year. If it took an 8% hit, its net asset value would drop to $102.75, about where it was trading on Oct. 5, 2009, when a 10-year TIPS was yielding 1.51%.
I repeat: Perfectly reasonable. Will this happen? Who knows? But no one should be surprised if it does.
Treasury Inflation-Protected Securities 
https://tipswatch.com/2012/02/23/how-risky-are-tips-mutual-funds-and-etfs/
You called this two years ago, the problem is always to get the timing right. If you could do that you wouldn’t be writing this blog, you’d be quaffing jello shots with George Soros at Davos.
BY, I totally agree I got out of the TIPS funds too early. I had bought in during the huge dip during the first days of the financial crisis, and then thought ‘good enough’ when I had an 18% capital gain. TIPS funds tend to be a minor part of my portfolio and I just prefer a Total Bond Fund for my core bond fund. It’s less volatile and well … boring. Here is a chart comparing the Vanguard TIPS fund in blue versus the Vanguard Bond Fund, in red, from the summer of 2011 to today:
That’s really the wrong way for your brother in law to look at things. Everyone who held that TIPS fund lost the same percentage. Losing 8% was implicit if interest rates went up by 1% which, given how low they were, certainly was well within the range of expectable probable outcomes, even if the timing of the rate rise was unknown.
I think it was more painful because the rate rise occurred within a short time span. Had the same rate rise been spread out over the past couple of years it would have been less psychologically painful.
The other side of the coin is let’s say unexpected inflation took off, let’s say 4% annually, if so, suddenly that TIPS investment probably would have shown a healthy capital gain. But the other portfolio investments might have been hurt such as nominal bonds and stocks.
So your bro in law needs to think some more about why he has TIPS in his portfolio. If he’s getting upset about something that was reasonably likely to happen then he needs to think about his strategy some more.
Your “…. inflation took off …” phrasing led me to the following thoughts. The Fed has a low inflation track record lately, leading to significant public expectation of continued low inflation. Positive for trust.
But the Fed has coexisted in silence ‘forever’ with keeping these compelling & consequential real asset price histories
http://www.showrealhist.com/yTRIAL.html
nearly never shown to the public. Negative for trust.
NOTE the differential in durations: lately, forever.
BY, no doubt that risk was building in TIPS mutual funds. I began warning about this in the summer of 2011, way before TIPS hit their peak. I got entirely out of TIPS mutual funds in 2011 and returned in a small way in the fall of 2013. I prefer to buy individual TIPS in a ladder and hold them to maturity, and I don’t really care what happens on the secondary market. But I am picky about which TIPS to buy, and when.
Still, TIPS mutual funds are generally considered one of the safest and most conservative investments, so an 8% drop in one year is a rather big shock. What people don’t realize:
1) the big TIPS mutual funds are moderate- to long-term bond funds, and so they are more volatile.
2) TIPS prices were driven up by Federal Reserve bond-buying, which at the same time triggered fears of inflation and created even more demand for TIPS. The prices – resulting from yields negative to inflation – got way out of line.
Then in mid 2013, people realized that inflation wasn’t an immediate fear and the Fed was cutting back on bond buying, so there was the double whammy of declining demand. TIPS were hit much harder than other bonds and Treasurys.
The next drop – if it comes – will probably more in line with the overall bond market, but it could still be a nasty surprise for someone who doesn’t understand how bond funds work.
This raises a very interesting market timing question. When to switch out of TIPS when they seem expensive? Using either Total Bond Market or Intermediate Term Treasury Index as alternatives (obviously they have somewhat less duration than the VIPSX vanguard intermediate tips fund).
https://personal.vanguard.com/us/funds/vanguard/compare?navigatingFrom=2
Hopefully this link showing a chart of the comparison works. Depending on when you bailed out of tips in 2011, it’s not at all clear that the market timing effort would have had you significantly better off (assuming when you sold the tips you switched into some flavor of nominal bonds). Obviously anyone who bought in at the peak of the tips chart would be hurtin’ & cryin’. But starting from three years ago, to now, all three funds would have total returns pretty close to one another, and you couldn’t say it wasn’t just “noise.” What’s most interesting is that it really does seem as if Tips are NOT the “same” as “nominals + inflation”, there is a volatility aspect or lack of correlation at certain times. That might indicate they are good to have for the diversification of the bond portfolio even if that occasionally means an unpleasant surprise.
The usual well thought out analysis I would say. As far as bond funds ago it could be a shocker to some. My brother-in-law lost 8% in Vanguard’s longer term TIPS fund last year which effectively canceled out all his contributions for 2013. He was NOT pleased. Fred
Dave,
Thanks much for this! And, please, what is your prediction for the I-bond fixed rate, starting May 1
My prediction (wild guess) is that the rate will stay at 0.2%. The Treasury gives no hint of how it picks this rate, but I suspect it will want to keep the rate at least 0.2% because the inflation adjustment rate is going to be miserably low for six months after May 1.
Superb, as always. Thanks for all you do.
Joe McQuade
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