“The recession isn’t going to happen tomorrow, but it will happen next year.”
Tipswatch.com
As we all expected, the Federal Reserve raised its key short-term interest rate by 50 basis points on Wednesday, while also announcing plans to begin paring back its balance sheet in June. And then .. the stock market roared about 3% higher on the news. Federal Reserve Chairman Jerome Powell triggered the surge with these words at his afternoon press conference:
So a 75-basis-point increase is not something the committee is actively considering. … there’s a broad sense on the committee that additional 50-basis increases should be on—50-basis-point increases should be on the table for the next couple of meetings.
It was a brilliant move by the Fed, in my opinion. Brilliant in the sense of setting up expectations in recent weeks — a 75 basis point increases was “possible” — and then knocking down that idea, making multiple increases of 50 basis points seem appealing. The stock market, which has been slumping for weeks, celebrated with a one-day party.
That’s how I saw it. Now let’s hear from Michael Ashton, an inflation guru who explains his thoughts just about weekly in his “Cents and Sensibility” podcast. In this episode, titled “Reflections on this Century’s First 50bp Rate Hike,” Ashton points out that the Fed did what was expected, and there is no danger in doing what is expected.
But he also warns about complacency on the U.S. economy, which could be heading toward a difficult stretch, even with inflation continuing in a 4% to 5% range next year:
I can’t think of any examples in history where you had a large increase in energy prices, not to mention food prices, and large increases in interest rates … and didn’t have a recession. That would be very odd. … The recession isn’t going to happen tomorrow, but it will happen next year.
And this forecast raises the “big” question: Will the Fed have the nerve to continue fighting inflation even when stocks fall into a bear market and the economy is suffering? Ashton contends that the “Fed put” — its resolve to protect the stock market — remains alive, even it it is in hiding.
Here is his podcast intro:
Today the Federal Reserve raised the overnight Fed Funds rate 50bps – the largest such increase since May 2000 (and the Inflation Guy is sticking by the title of this episode since technically the 20th century didn’t end until 12/31/2000!), and Chairman Powell strode confidently to the microphone in the post-meeting presser. How does this action, and what Powell said, impact the inflation outlook and why did the markets behave the way they did? (The answers are: not much, and for unhealthy reasons, but listen to the podcast anyway.)
Who is Michael Ashton?
His audiences know him as the “Inflation Guy.” He is a pioneer in the U.S. inflation derivatives market. Before founding his company, Enduring Investments, Ashton worked in research, sales and trading for several large investment banks including Bankers Trust, Barclays Capital, and J.P. Morgan.
Since 2003, when he traded the first interbank U.S. CPI swaps, and 2004 when he was the lead market maker for the CME’s CPI Futures contract, he has played an integral role in developing new instruments and methods for accessing and hedging various inflation exposures. In 2016, Mr. Ashton published What’s Wrong With Money? The Biggest Bubble of All. He is a graduate of Trinity University and lives in Morristown, New Jersey.
Have a question? Get the Inflation Guy app in the Apple App Store or Google Play, or email InflationGuy@enduringinvestments.com.
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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.
Treasury Inflation-Protected Securities 
Jim Grant (Interest Rate Observer) was on another podcast I listen to recently. His opinion is that the 10 year treasury should be yielding at least 5%, even if inflation decreases into the 3-4% range. Essentially using a rule of thumb that interest rates ought to be 2% above inflation rate, in order to give creditors a fair return.
DW, I agree with Jim Grant. If inflation continues at 3.5% or higher, the 10-year Treasury should get to at least 4.5%, and the 10-year real yield should rise to at least 1.0%, and more likely 1.5%. That is historically normal. That assumes, however, that the Fed doesn’t step in again to bolster the bond markets and send yields plummeting.
I have money in a tips fund with my IRA.
I know the value of the funds components will change, but doesn’t the inflation related payments counteract this to some degree? Or perhaps even end up being larger than the lost value of the fund assets held over the same period, during periods of relatively high inflation like we are experiencing now?
Seems like that is what I have experienced over the years, but perhaps I do not pay enough attention…
TIPS funds are a bit complicated, because they pay the inflation accruals as current income. So you can’t just focus on the net asset value of the fund, which won’t reflect the paid-out inflation accruals. For example, the TIP ETF started the year with a net asset value of $128.46, and now has a value of $118.18. That’s a decline of 8%, but its year to date total return is -6.5%, so the inflation accruals helped. In addition, there is a lag time in the inflation payout, and April’s inflation accrual of 0.91% will be paid this month, and May’s increase of 1.34% will be paid out next month. (And the value of the fund should reflect these future payouts.) The main point: Focus on total return. Here is a helpful fact sheet: https://www.ishares.com/us/literature/brochure/mechanics-of-tips-en-us.pdf
I purchased 10 year TIPS at auction through Fidelity earlier this year. It shows that is already down over 7%. Will brokerage accounts automatically adjust the principle (current value) within the account’s table shown on my TIPS as time progresses or do I need to multiply it by the inflation factor?
Yes, the brokerage should show an adjusted price based on both the current market value and the inflation adjustment. If you are holding the TIPS to maturity, you can simply multiply par value x the inflation adjustment and track that until maturity.
Wonderful. Thanks for explaining so clearly.
Well, the FED propped-up the economy during the Great Recession.
Then, the FED did more of the same during the Pandemic.
Now, it needs to realize that the economy and the stock market are two different entities.
And, raise rates to at least neutral territory and unwind QE to restore normalcy to the bond markets.
Otherwise, they’ll have nothing available to deal with the next unforseen global emergency.
This stuff has been going on for much too long now.
Help me understand TIPS funds. I get that assets of TIPS funds are Treasury securities. And when rates rise the value of said assets declines. At the same time when inflation is high the inflation adjustment should offset the decline in the Treasury holdings. All that said in 2022 the value of TIPS FUNDS have declined. In nominal terms I am losing principal. If I had left the money in the cookie jar I would be even thru May 5th. I know my money is losing buying power but my cookie jar isn’t losing principal as well. If TIPS funds are net losers now,,,,,, when in the future will they thrive? I think that they have been oversold.
Keep in mind that the broad TIPS funds (like the TIP ETF) had a total return of about 8.3% in 2019, 10.8% in 2020 and 5.9% in 2021. Those were out-sized gains caused by the collapse in real interest rates. The 10-year real yield fell from about 1.15% in November 2018 to to a low of about -1.17% in August 2021. That’s a 232-basis-point swing, and TIPS funds benefited. Now the 10-year real yield is around 0.17%, That’s a swing upward of 134 basis points, and TIPS funds have suffered. Even inflation running at 8.5% can’t overcome that sort of rise in real rates, especially when you are starting with yields negative to inflation. I think the 10-year real yield could potentially rise to 1.0%, or higher. There’s a ways to go, possibly.
Thanks for your reply. I understand what happened in a declining interest rate environment. That is ancient history. My concern is what is happening in todays RAISING rate environment. My expectation of my TIPS investment was not that it would return more than inflation but I did not expect it to lose money in nominal terms in times of high inflation. Obviously I need to rethink this.
My view is that TIPS funds (and all high-quality bond funds) will be getting more attractive going forward. How long will the Fed continue tightening? The 5-year and 10-year nominal Treasury are now above 3%, so that means things are starting to normalize. But inflation has to come down.
@Paul,
I think your misunderstanding has less to do with how TIPS work than how bonds vs. bond funds work. Bond funds, just as with individual bonds, lose value when rates rise because the new rates are the “better deal in town”. However, one doesn’t really “see” that with individual bonds if held to maturity.
What TIPS do compared to nominal bonds is protect against unexpected inflation. We can check out real-life total returns head to head as a way to see the benefit. For this, let’s compare the total returns of nominal bond funds VGSH (1.9-yr avg duration) and ISTB (2.8-yr duration) to TIPS bond fund VTIP (2.5-yr avg duration)…all numbers from Portfolio Visualizer:
2019: VGSH = 3.52% | ISTB = 5.61% | VTIP = 4.86%
2020: VGSH = 3.04% | ISTB = 4.76% | VTIP = 4.95%
2021: VGSH = -0.60% | ISTB = -0.71% | VTIP = 5.36%
2022 (4 mo): VGSH = -2.99% | ISTB = -4.57% | VTIP = -0.47%
For a “normal” time period where inflation basically meets expectations, one expects to see VTIP fall between the two nominal funds because of its intermediate duration (TIPS also typically have a lower return as a premium due to its inflation “insurance”, though it’s often small). That’s exactly what we see in 2019, where there were no inflation shocks (and the decrease in interest rates gave existing bonds great returns).
In 2021, unexpected inflation started hitting hard, and we see VTIP blow away the nominal bonds. The nominal bonds were negative in nominal terms because of the market pricing in upcoming rate hikes for early 2022.
In 2022 (first 4 months), inflation hit harder than expected, so once again VTIP blew away nominal bonds. However, rates are looking to increase much more than was priced in at the end of last year, so all the funds are negative. The rising rates also show why ISTB has been hit so much harder than VGSH–its duration is longer (which is why it benefitted more in 2019/2020 too). An even greater example of this is the EDV fund (avg duration of 24.6 yr)…it is down 24.0% over the first four months of 2022…yes, a bond fund down that much!
So the above shows that TIPS funds are doing their job of protecting against unexpected inflation relative to nominal bonds. Unfortunately, they don’t protect against rate hikes too. That’s one of the advantages of I Bonds, and also one reason why they’re purchase limited, as they can sometimes be switched out to take advantage of higher rates with much less penalty than one would incur with TIPS. I don’t see that advantage of I Bonds spoken to nearly as often as it should be…