Treasury Inflation-Protected Securities

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?

This full 9-article series:

• 2013: A year of surging real and nominal yields
• 2014: The deck was stacked against TIPS funds
• 2015: The Fed actually did something!
• 2016: Inflation rises; TIPS out-perform the overall bond market
• 2017: ‘The calm before the storm’
• 2018: Did the Federal Reserve go too far?
• 2019: The Fed cries ‘uncle’; bond investors celebrate
• 2020: Chaotic year of pandemic fears, stunning stimulus
• 2021 and beyond: What’s ahead for U.S. financial markets?

* * *

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.

By David Enna, Tipswatch.com

This article is the eighth in a series looking at how my three favorite bond funds — Vanguard Short-Term Inflation Protected (VTIP), Schwab U.S. TIPS (SCHP) and Vanguard’s Total Bond (BND) — performed after 2013, when the Fed signaled it would back off on bond purchases and eventually raise short-term interest rates.

Why do this? Because we may be heading into a similar scenario in 2022 and beyond, with the Fed tapering bond purchases and eventually (and gradually) raising short-term interest rates. The performance after 2013 could tell us a lot about what’s ahead.

To recap, here are the three bond funds I am tracking; they are three conservative, liquid, mainstream bond funds with very low expense ratios. Here’s a summary of their basic statistics and performance:

2020: A chaotic year of pandemic fears, stunning stimulus

Let’s recall that 2020 started off with U.S. investors fearing a coming recession. In 2019, the Federal Reserve had already cut its key short-term interest rate three times. The yield curve had flattened, and TIPS with terms up to 10 years already had real yields close to zero. On Jan. 24, 2020, a 10-year TIPS auctioned with a real yield of 0.03%, the lowest in seven years.

So the financial markets were already facing low-level chaos. It was about to get a lot worse. Global awareness of the COVID-19 pandemic began rising in January, but gradually. Between January 21 and February 23, 2020, 14 coronavirus cases were reported by U.S. health agencies. The first non-travel case was confirmed in California on Feb. 26, and the first U.S. death was reported on Feb. 29. By March 15, two weeks later, the U.S. had reported 3,485 cases and 65 deaths. One week later, on March 22, the case total rose to 34,000 and deaths reached 413.

The escalating pandemic caused full-out panic in the financial markets. The S&P 500 stock index fell about 25% in the three weeks from March 1 to March 20, plummeting into a bear market. Bond markets were roiled, with yields rising and falling in seemingly random patterns. The financial system was in severe stress.

The Federal Reserve stepped in quickly to calm the markets and Congress soon followed along with a series of historically massive stimulus packages, many of which remain in effect today. Here is a rough timeline of the stimulus pouring into the U.S. economy:

• March 3, 2020: The Federal Reserve cut its federal funds rate by 25 basis points, to a range of 1.00 – 1.25%.
• March 15: Federal Reserve met on Sunday to cut short-term interest rates 100 basis points (effectively to zero) and launched another round of “quantitative easing,” a $700 billion program of bond buying. “There’s no monthly cap, no weekly cap,” Fed Chair Jerome Powell said. “We’re going to go in strong starting tomorrow.”
• March 17: Federal Reserve created a Commercial Paper Funding Facility to protect short-term corporate debt.
• March 18: Federal Reserve created a Money Market Mutual Fund Liquidity Facility to protect funds investing in corporate debt.
• March 20: The Fed opened its money market program to include high-quality municipal debt.
• March 23: The Fed expanded its quantitative easing bond-buying to include mortgage-backed securities.
• March 23: The Fed created the Primary Market Corporate Credit Facility to buy corporate bonds.
• March 26: The New York Fed announced plans to buy corporate bonds and bond exchange-traded funds on the secondary market.
• March 27: President Trump signed into law the $2.3 billion CARES Act, providing a direct cash payment of $1,200 per person, plus $500 per child. It also provided an additional $600 unemployment benefit per week. The CARES Act also created a moratorium on evictions.
• April 6: The Fed announced the Main Street Business Lending Program, that would purchase $600 billion of debt from companies employing up to 10,000 workers or with revenues of less than $2.5 billion.
• April 6: The Fed announced a a new emergency lending facility, the Municipal Liquidity Facility, that would purchase $500 billion of debt from states and cities.
• April 24: Congress passed a $484 billion supplementary stimulus package, mostly to support the Payment Protection Program.
• Aug. 10: Trump, by executive order, extended a $400-per-week payment to those currently receiving unemployment payments.
• Dec. 27: Trump signed a $900 billion stimulus and relief bill that included direct payments of $600 per person, with some income limits. It also continued expanded unemployment benefits.
• March 11, 2021: President Biden signed the American Rescue Plan Act of 2021, a $1.9 trillion package that included direct cash payments of up to $1,400 for individuals earning less than $75,000 a year, plus $1,400 per dependent.

Stimulus. It works.

My focus in these articles is to track how our three bond ETFs — VTIP, SCHP and BND — performed in the period from 2013 to 2021, a time when at first the Federal Reserve was unwinding quantitative easing and ultra-low interest rates, and then a few years later, launching even bigger quantitative easing and returning to ultra-low interest rates.

But I can’t ignore noting that the S&P 500 had a total return of 18.22% in 2020, after falling deep into bear market territory in March.

For the bond market, the Fed actions (along with general market chaos) resulted in a deep decline in both real and nominal interest rates. Real yields took a deeper fall, as investors began realizing all this stimulus raised the specter of rising inflation:

All of this was “very good news” for the bond market (and especially TIPS) in a very bad year of locked-down life in the United States. Here is how our three funds performed, with the chart showing net asset value, excluding distributions:

Just like the stock market, the bond market took a beating in March 2020 as financial chaos set it. This is why the Federal Reserve stepped in (on March 15, a Sunday) to slash short-term interest rates to near zero. Four days later, the Treasury staged a reopening auction of a 10-year TIPS, CUSIP 912828Z37, that resulted in an inflation breakeven rate of 0.43%. That’s right, in mid-March 2020, investors expected inflation to run at 0.43% over the next 10 years. The real yield at that auction came in at 0.68%.

But things turned around quickly as stimulus poured into the system. By May 22, CUSIP 912828Z37 had another reopening auction and got a real yield of -0.47%, a drop of 115 basis points in 2 months. Its inflation breakeven rate was 1.14%. Things were clearly settling down as the Federal Reserve began aggressively buying bonds at a rate of $120 billion a month.

Inflation dipped in 2020 to an annual rate of 1.4%, which dampened the return of the TIPS funds, but rising inflation expectations gave those funds a boost in net asset value. Schwab’s U.S. TIPS ETF, SCHP, was easily the top performer of the year for this group, but both BND and the shorter-term and less-risky VTIP also had very good years.

Conclusion

Although 2020 ended up being an excellent year for both bond and stock investors, let’s hope we never have to relive a year like that. The Federal Reserve and Congress acted to stave off financial disaster, and we are living with the result of those actions today as U.S. inflation soars to 5.4%, a 12-year high.

The events of March 2020 stunned me. When the Federal Reserve announced a new wave of quantitative easing on March 15, my immediate reaction was that real yields for TIPS would be heading lower — probably deeply negative to inflation. And yet, four days later, a 10-year TIPS got an auctioned real yield of 0.68%, about 65 basis points higher than expected. This was financial panic in action. The Federal Reserve’s actions halted that panic and then my logic held true: a 10-year TIPS is now yielding -0.94%.

Coming tomorrow: A look at 2021 and beyond

• 2013: A year of surging real and nominal yields
• 2014: The deck was stacked against TIPS funds
• 2015: The Fed actually did something!
• 2016: Inflation rises; TIPS out-perform the overall bond market
• 2017: ‘The calm before the storm’
• 2018: Did the Federal Reserve go too far?
• 2019: The Fed cries ‘uncle’; bond investors celebrate
• 2021 and beyond: What’s ahead for U.S. financial markets?

* * *

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.

By David Enna, Tipswatch.com

This article is the seventh in a series looking at how my three favorite bond funds — Vanguard Short-Term Inflation Protected (VTIP), Schwab U.S. TIPS (SCHP) and Vanguard’s Total Bond (BND) — performed after 2013, when the Fed signaled it would back off on bond purchases and eventually raise short-term interest rates.

Why do this? Because we may be heading into a similar scenario in 2022 and beyond, with the Fed tapering bond purchases and eventually (and gradually) raising short-term interest rates. The performance after 2013 could tell us a lot about what’s ahead.

To recap, here are the three bond funds I am tracking; they are three conservative, liquid, mainstream bond funds with very low expense ratios. Here’s a summary of their basic statistics and performance:

2019: The Fed cries ‘uncle’; bond investors celebrate

Something significant happened at the end of 2018: After the Federal Reserve raised short-term interest rates in December — for the fourth time that year — stock market investors threw a fit, with the S&P 500 plunging nearly 15% in the first three weeks of December. The Federal Reserve got the message: It was time to change course.

During years of stock market gains from 2013 through 2016, the Fed had acted slowly to raise short-term interest rates from a near-zero level, by 25 basis points in 2015 and and another 25 in 2016. This was after S&P 500’s total return gained 32.2% in 2013, 13.5% in 2014, 1.3% in 2015, and 12% in 2016. But in 2018, the stock market had a negative return, with the S&P’s total return falling by 4.6%. That is the only year in the 2013 to 2021 period that the stock market had a negative return.

So, what did the Federal Reserve do? Here are its actions to reduce its federal funds rate in 2019:

• July 31, 2019: Reduction of 25 basis points, to a range of 2.00 – 2.25%.
• Sept. 18, 2019: Reduction of 25 basis points, to a range of 1.75 to 2.00%
• Oct. 30, 2019: Reduction of 25 basis points, to a range of 150 to 1.75%

In addition, the Federal Reserve announced in October 2019 that it would relaunch “pseudo” quantitative easing, with plans to buy $60 billion of Treasury bills per month. The Fed claimed this wasn’t QE, but an attempt to add short-term liquidity to the market. “These operations have no material implications for the stance of monetary policy,” the Fed said in a statement.

And here is how the bond market reacted, with both real and nominal yields falling across all maturities:

The year 2019 set up a very good scenario for TIPS investors: Real yields were falling deeply, while inflation maintained at a brisk level of 2.3% for the year. That combination gives TIPS investors capital gains, combined with gains in inflation accruals. The overall bond market also benefited from fairly deep declines in nominal rates. Here is how the net asset value of our three funds performed 2019, not including distributions:

Vanguard’s short-term TIPS fund, VTIP, with its shorter duration, was the laggard in this group, but it still had a good one-year performance. When distributions are added in Vanguard’s total bond ETF, BND, was the best performer of the three, just edging out Schwab’s U.S. TIPS ETF.

All of that looks fantastic — and it is fantastic — except when you look at the total return of the S&P 500 in 2019, up a glorious 31.2%, easily overwhelming its paltry 4.6% decline in 2018. The Federal Reserve heard the stock market’s bellows of pain in December 2018, and responded with three cuts in short-term interest rates. The “easy money” game was on again.

Conclusion

It’s odd, but my memory of 2019 was that the U.S. economy was heading toward recession and the Federal Reserve was working feverishly to avoid that, slashing interest rates and launching some sort of Treasury-bill QE. But, in reality … inflation ran at an above-target 2.3% for the year, and U.S. GDP grew 2.2% for the year, a reasonable rate. The U.S. stock market had a total return of 31%. The bond market cranked out gains of nearly 9%. And all this happened while the Federal Reserve was easing monetary policy.

This was all very weird. Except … nowhere near as weird as what was coming in 2020.

Coming Tuesday: The June inflation report

Coming Wednesday: A look back at 2020

• 2013: A year of surging real and nominal yields
• 2014: The deck was stacked against TIPS funds
• 2015: The Fed actually did something!
• 2016: Inflation rises; TIPS out-perform the overall bond market
• 2017: ‘The calm before the storm’
• 2018: Did the Federal Reserve go too far?
• 2020: Chaotic year of pandemic fears, stunning stimulus
• 2021 and beyond: What’s ahead for U.S. financial markets?

* * *

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.