Macro: Sandcastle economics
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Stagflation: the revival of Treasury Inflation-Protected Securities (TIPS)
Althea Spinozzi
Head of Fixed Income Strategy
Summary: As inflation remains elevated and the economy stagnates, Treasury Inflation-Protected Securities (TIPS) provide a hedge against stagflation. We remain cautious, favoring quality and short duration. At the same time, we believe long-term rates are poised to rise further, with 10-year yields likely to test their November's high at 4.31%. Overall, we continue to favor steepeners.
SaxoStrats has changed its outlook from non-recession to stagflation light. However, what does it imply for bond investors?
With stagflation, economists refer to a period when the economy slows but doesn't enter into a full-blown recession while inflation remains persistently high. Such a scenario implies that the Federal Reserve won't be able to hike interest rates aggressively to fight inflation as it did during the past year. Still, it will need more basis to cut rates as it did not enter a recession. Within such a scenario, it's most likely to see rates trading rangebound until a recession or a recovery set the direction.
As Steen Jakobsen explains, the outcome will be an imperceptible quasi- “Yield Curve Control” monetary policy as it will not want rates to rise too much, but even not to drop drastically. That creates the perfect environment for real money to build on their bond portfolio, taking advantage of multi-year high yields.
Stagflation: which investment makes sense?
(1) Front-end inflation-linked bonds. It’s the ultimate stagflation play. With the Fed unable to hike or cut too much, the nominal component of inflation-linked bonds will be anchored. However, their principal will increase together with inflation, and investors will receive a fixed rate of interest every six months based on the adjusted principal of the bond until it matures. Although the securities' coupon will indeed fall as inflation decreases, it’s important to note that when the TIPS matures, you will get the increased amount if the principal is higher than the original amount. If the principal is equal to or lower than the original amount, you get the original amount[1]. Also, TIPS will benefit from potential interest rate cuts.
To understand how these securities behave in one's portfolio is helpful to compare TIPS total returns with those of nominal bonds. In 2021 and 2022, the convenience of holding short-dated TIPS versus Treasury has been staggering. While 1-to-5-year US Treasuries tumbled by -5.5% in 2022, TIPS lost only -2.7%. The reason for such outperformance lies in the inflation component, which creates a buffer against high inflation. However, TIPS do not provide a hedge against interest rate hikes, hence explaining the loss.
As inflation remains elevated and there is the risk of rising again in the last quarter of the year, we favor short-term inflation linkers. Below, you will find a list of TIPS with a maturity of up to two years.
(2) Short-term US Treasuries. Central banks across both sides of the Atlantic have undertaken the most aggressive interest rate hiking cycle in centuries. Today investors have the chance to lock in one of the highest yields in decades, with US two-year yields paying almost 5%. As economic activity slows, the Fed might be unable to continue hiking, putting a cap on rates. At the same time, if the economy enters into a recession, the front part of the yield curve has the potential to collapse quickly, providing upside to bondholders.
(3) Short-dated investment-grade corporate bonds. As stagflation will put weaker corporates under pressure, we prefer quality over junk. Moreover, we favor short-dated corporate bonds with 1 to 5 years of maturity over longer maturities. Indeed, despite offering a considerably higher yield than historically, longer-dated corporate bonds don’t reward investors for taking on higher duration risk. Additionally, while the front part of the yield curve is capped amid a stagflationary environment, long-term rates can rise further as jobs and growth deteriorate slowly.
Why might long-term rates continue to rise?
Although we expect a slowdown in growth, we do not expect a blown-out recession and severely high rates of unemployment. That will allow the Fed to hold rates higher for longer, creating a natural floor for rates. However, mixed data and elevated inflation will contribute to higher rates.
Although we don't believe that the economy is facing the same stagflation woes of the '70s, it is helpful to see how rates reacted then to understand how they might behave today. Stagflation is defined as the CPI rate plus unemployment rates minus the real growth rate. If we chart this line together with 10-year US Treasury yields, we will see that during periods of stagflation, yields rise rather than drop.
For stagflation risk to increase, it is unnecessary to see a pickup in inflation; higher unemployment and growth deceleration will lead to the same result. Economists and central banks are already estimating rising unemployment and lower growth by year-end; therefore, the blue line will certainly tick up with 10-year yields following.
Hence, ten-year Treasury yields will likely soar to test their November high at 4.31%. Yields will remain in an uptrend unless they break below 3.75%.
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