Don't Count Out TIPS as the Hedge for a Bear Bond Market
The market for Treasury Inflation-Protected Securities has had plenty of critics since the U.S. government began offering the bonds 20 years ago. The naysayers say the securities lack liquidity, don’t have broad appeal or are too costly for the Treasury Department to issue.
Now, their reputation may be about to improve as they become a critical hedge against risk.
In a recent speech on the inner workings of the market for U.S. government bonds, Federal Reserve Governor Jerome Powell attempted to prove that nominal Treasuries had been a “good hedge against market risk” in the past few years.
The basis for his argument was that the beta of Treasuries and equities -- the returns compared with those of financial markets in general -- has been closely correlated with a decline in the “term premium,” essentially a metric that reflects the extra yield investors demand to hold longer-maturity debt instead of successive short-term securities. When the excess risk of holding longer maturity bonds declined, and inflation expectations stabilized, nominal Treasuries were an attractive hedge that contributed positively to the total return of a riskier portfolio.
Low rates of inflation created a favorable climate for government bond returns over the past few years. This is now changing, with energy prices, wages and producer prices firmly on the rise. Deflation no longer is a bigger risk than inflation.
The derivatives market shows that the premium of inflation swaps with a 0 percent inflation floor has fallen to the lowest level since the end of the financial crisis. That indicates that the inflation swap market considers future deflation risks to have diminished significantly. Yet, inflation expectations as measured by the five-year inflation swap, traded five years forward, show a big jump since the U.S. presidential election. In other words, the market sees a decent chance that inflation may rise above the Fed’s target of 2 percent and hold there.
The shift in market perception regarding TIPS could have material impact on the effectiveness of nominal Treasuries as a hedge against market risk.
First, in an economy where fiscal stimulus and monetary tightening are the new policy mantra, Treasury returns may prove to be more consistently negative when spending boosts investment that sparks growth and faster inflation.
Second, deficit financing would come from the large scale issuance of Treasuries rather than through quantitative easing, which would push yields higher.
Third, as inflation settles close to or above the Fed’s target, further tightening of monetary policy could be achieved by shrinking the central bank’s balance sheet, which could increase the amount of nominal Treasuries the market has to absorb.
Finally, successful fiscal policy that boosts productivity and raises potential output should lead to a normalization of the neutral rate of interest from current negative levels. These factors would cause changes to term premiums, reducing the hedge effectiveness of nominal Treasuries.
And the market has begun to price such a scenario. That can be seen in Powell’s measure of a perfect hedge: the correlation between the Treasury-equity beta and the term premium. The correlation has recently fallen to a less negative value. The beta of TIPS to equities as measured in the correlation to the term premium has increased however to close to -1. That suggests TIPS may now be close to “perfect” hedge against market risk. With inflation expectations shifting to a higher range, the change in correlation of TIPS and term premium may signal that a bear market in nominal bonds may be beginning, depending on changes in the overall macro economy.
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