Inflation Protection ETFs Are Climbing

April 07, 2016

(Reuters) – After months of angst about deflation that has led many central banks to adopt negative interest rates, there's been a sudden burst of speculation that inflation may be back.

In the United States and Britain at least, many investors are betting that inflation has reached its nadir and are seeking to insulate their portfolios against rising consumer prices.

Demand for U.S. Treasury inflation-protected securities is at its strongest in years, while benchmark TIPS exchange-traded funds have recently chalked up their best quarterly performance in 12 years.

TIPS purchases are being recommended by giant asset managers BlackRock and PIMCO and banks such as Morgan Stanley, while economists at Citi say the "lowflation" that has defined the U.S. and British economies in recent years seems to be ending.

‘Valuations Attractive’

"Even if core inflation stays where it is, buying a TIP will return 70 basis points more than buying a nominal Treasury bond," said Shyam Rajan, head of U.S. rates strategy research at Bank of America Merrill Lynch (BAML) in New York. "Valuations are very attractive. Breakevens are still cheap by any metric."

The yield premium on regular U.S. Treasurys is currently 1.75%, and the yield on TIPS is 0.15%, giving a breakeven rate of 160 basis points. With U.S. core inflation now running at 2.3%—a four-year high—investors can pick up a real return of 70 basis points.

Inflows Following Performance

Investors are flocking to TIPS products. According to BAML, investors have been net buyers of TIPS funds for seven-straight weeks, the longest run in almost a year. Cumulative inflows into these funds now stand at $4.8 billion, also the highest for nearly a year.

Moves this year in the benchmark TIP exchange-traded fund tell a similar story. The $16.7 billion ETF iShares TIPS Bond (TIP | A-99) rose 4.4% in the first quarter of the year, its best quarterly performance since the same three-month period in 2004.

Similar performance has been seen with the Schwab U.S. TIPS (SCHP | A-100) with $1 billion in assets; the SPDR Barclays TIPS (IPE | A-89), with $665 million in AUM; and the PIMCO Broad U.S. TIPS (TIPZ | B-87), with $89 million in assets.

Chart courtesy of StockCharts.com

"Given the downside support from the Fed and the relatively low level of breakevens, we think investors should continue to maintain long positions in 30-year TIPS and in breakevens," Morgan Stanley told clients.

The U.S. five-year, forward rate used to measure inflation expectations rose as high as 1.75% late last week compared with post-crisis lows of 1.42% in February.

Transatlantic Divergence

The big question is whether the picture in the United States—and to a lesser extent Britain—is exceptional or whether it is a bellwether of global inflation trends.

In Europe and Japan, inflation remains near zero, and any significant rise appears a distant prospect, as cheap oil, the slowdown in China and other emerging economies, and the U.S. dollar's rise of over 20% in just four years weigh.

More than $6 trillion of European and Japanese sovereign bonds currently trade at negative yields, suggesting investors remain skeptical that years of extraordinary monetary stimuli from central banks will reignite consumer price inflation.

German 10-year nominal bond yields shrank below 0.10% for the first time in a year this week, and economists talk of negative central bank deposit rates persisting for years.

Eurozone five-year inflation swaps are falling back toward February's record low of 1.36%, while even the University of Michigan's five-year U.S. inflation outlook index is hovering around its lowest ever, comfortably below 3%.

‘More Positive Backdrop’

Jamie Searle, rates strategist at Citi in London, says there may be signs that European demand for inflation protection is slowly beginning to pick up, particularly from investors looking to hedge longer-term inflation risk.

"There's a growing sense that the bounce in U.S. TIPS has helped create a more positive backdrop. It's quite tentative though—we're not talking about a broad-based pickup in global inflation here," he said.

So much now hinges on the oil price.

After rallying more than 50% from lows earlier this year, world crude is struggling to get a foothold above $40/barrel. The persistent supply glut and ebbing global demand suggests $30/barrel could be revisited as easily as $50, especially if no meaningful deal to limit production is struck.

But some think the rollback in U.S. shale oil output that is already underway—itself a response to the oil price collapse—may be enough to create a price floor.

"While there are near-term downside risks to prices as the market continues to rebalance, the medium-term forwards ... may actually under-price how we expect fundamentals in the energy market to evolve," Goldman Sachs strategists Francesco Garzarelli and Rohan Khanna wrote in a research note on Tuesday.

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