David Rogal and Bob Miller contend that the TIPS market dislocations witnessed in recent months have resulted in opportunities that investors would be remiss to ignore.
Sparked by a global collapse in activity in response to the Coronavirus pandemic, the increase in volatility and resulting market dislocations have created investment opportunities (and risks) that bond markets haven’t seen in more than a decade. Treasury Inflation Protected Securities (TIPS), alongside many other fixed-income sectors, were hit hard by a series of negative fundamental and technical catalysts.
Treasury market dislocations
The world’s “risk-free” asset, U.S. Treasuries, experienced substantial market dislocations during this period. Dealer balance sheets became clogged with off-the-run Treasuries, as margin calls, exchange margin hikes, and repo scarcity prompted a rapid deleveraging process. Combined with stricter bank capital rules today versus ten years ago, market-makers were unable to effectively intermediate trading activity. And TIPS were not immune to the deterioration in market function. Further, break-evens fell sharply, and off-the-run TIPS cheapened in dramatic fashion relative to recently issued TIPS. They also under-performed nominal Treasuries of late.
In response to this situation, the Federal Reserve has acted in an unprecedentedly swift and aggressive manner to counter these dislocations, and while markets haven’t fully returned to normal, the central bank’s efforts are having great effect. Over the five weeks to April 15, the Fed purchased more than $1.2 trillion in Treasury securities across the curve, including $83 billion in TIPS. These massive purchases helped to clean up dealer balance sheets and restore market function (see graph).
Market liquidity dries up, just as demand sharply increases
The TIPS market is about 8.5% of the outstanding value of the U.S. Treasury market, and its smaller size and unique risk characteristics have always demanded a “liquidity discount” that increases in times of extreme market stress. The well-known formula for TIPS break-even inflation, or the amount of realized inflation that equates returns on Treasuries and TIPS, can be expanded to account for this liquidity discount. Recently, markets saw an extreme increase in the demand for liquidity, as precautionary cash raising soared and risk aversion increased. This activity led to a sharp deterioration in market liquidity, causing liquidity discounts to expand substantially. As such, nominal yields fell dramatically relative to TIPS yields, resulting in a sharp contraction in break-even inflation rates and an under-performance of the TIPS market.
Additionally, we must recall that TIPS principle amounts are indexed to headline inflation, and as such TIPS performance is sensitive to energy prices, specifically, the price of retail gasoline, which is generally between 3% and 4% of the headline CPI index. As countries across the globe have locked down their economies and implemented social distancing to combat the spread of Coronavirus, oil demand has plummeted. Simultaneously, a feud between two of the world’s largest oil producers, Saudi Arabia and Russia, had seemed to limit the possibility of a supply response to offset declines in demand. Ultimately, OPEC and other major producers did agree on a significant cut to production, but its influence on the oil price may be modest.
In addition to liquidity considerations mentioned above, TIPS break-evens are sensitive to credit spreads and measures of expected volatility. Indeed, several measures of market risk premium have also risen dramatically, in response to a fundamental increase in economic risk. Jobless claims, one of the best high frequency indicators of economic activity, have increased dramatically in recent weeks. Even though core inflation has been relatively stable, it is not immune to economic disruption. Traditional demand shocks have relatively straightforward transmission mechanisms to realized inflation. Reduced demand should reduce the price to equilibrate supply, all else equal.