Investors Flock to Inflation Protection to Hedge Perfect-Fed Bet

Investors Flock to Inflation Protection to Hedge Perfect-Fed Bet

(Bloomberg) — Bond investors made clear this week that they doubt the Federal Reserve’s ability to return inflation to its 2% target.

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Yields on inflation-protected Treasury debt have climbed to levels about 2.3 percentage points lower than regular rates on US government bonds. The gap represents the average annual change in the consumer price index needed to equalize their returns.

If CPI inflation exceeds 2.3%, investors are better off buying TIPS, and on Thursday, they plunked cash on the barrelhead. An auction of new 10-year Treasury Inflation-Protected Securities drew a yield more than 5 basis points lower than where they were trading at the bidding deadline, a sign that demand exceeded dealers’ expectations.

Also Thursday, the iShares TIPS Bond ETF — a $21.6 billion behemoth bigger than all but two TIPS mutual funds tracked by Bloomberg — had a $193 million inflow, its fourth biggest this year.

Read: El-Erian Says US, UK Near-Term Inflation Targets Should Be 3%

Because the inflation gauge targeted by the Fed historically has been about a quarter point lower than the CPI rate, breakeven inflation rates for TIPS of about 2.3% are consistent with the Fed having impeccable aim.

Meanwhile, the targeted rate was 3.8% in June, down from a peak of 7% a year earlier, shortly after the central bank embarked on a series of 10 interest-rate increases that it’s expected to extend next week.

“The market’s priced for the Fed to be perfect forever,” said Michael Pond, head of inflation market strategy at Barclays.

But investors are skeptical, he noted.

“I can’t find any that say those levels are fundamentally rich,” Pond said. Rather, the predominant view is that wage growth and structural factors will keep inflation about a percentage point above the target, and the Fed will eventually acquiesce to it, he added.

Unlike in 2021 when investors flocked to TIPS as inflation took off, then suffered steep losses in 2022 as yields soared, TIPS yields remain at or near multiyear highs, providing a cushion in the event that inflation moderates toward the levels priced into the market.

For five-year TIPS, yields topped 2% this month for the first time since 2008. Thursday’s 10-year auction yield of 1.495%, though lower than expected, was the highest one since 2010.

“Real yields look attractive,” said James Evans, who manages inflation-protected bond funds at Brown Brothers Harriman & Co. “If you think inflation is going to be 3% for a while, that’s a pretty good real return.”

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