Treasury Inflation-Protected Securities (TIPS) will continue to outperform nominal Treasuries, besides providing a valuable hedge against inflation

TIPS will outperform nominal Treasuries in 2021 regardless of inflation

It is critical to understand that next year TIPS' performance does not depend merely on inflation.

In the past few weeks, the market has been focusing over the Federal Reserve course of action and the likelihood that it will need to expand its bond-buying program to buy longer-dated maturities in an effort to keep interest rates low for longer. If that were the case, TIPS prices would continue to be supported even if inflation will not rise.

This brings us back to the reflation theme, which has characterized the market since the US presidential election, provoking a steepening of the yield curve. Whenever we talk about the steepening of the yield curve, we have to put things into perspective. The yield curve can steepen because the front part of the yield curve falls faster than long-term yields (bull steepening). Otherwise, it can steepen because long-dated yields rise faster than near term yields (bear steepening).  Since the end of 2018 until recently, we have witnessed a bull steepener, but the Covid-19 pandemic changed this pattern, and the yield curve is now steepening because interest rates are soaring. The rise in the consumer price index has contributed to interest rates' acceleration, but as of August, it started to stabilize. Suppose yields continue to soar, but the CPI index lags. In that case, the Fed will not have other choices than keeping interest rates low for longer until inflation ticks up again.

Hence, in case of reflation, TIPS will provide a hedge, but in case inflation doesn’t rise we will most likely see the Fed keeping interest rates around current levels.

In this context, TIPS offer a win-win solution.

The biggest threat to TIPS performance at this point is rising interest rates without inflation catching up. If that were the case, the price of inflation-linked securities would fall, and the inflation hedge will not be activated, providing any extra cashflow. This scenario is not feasible as the Fed will not put at risk years of expansionary monetary policy. Not even deflation is a credible threat at this point of time as the macroeconomic backdrop points towards inflation.

The biggest market's problem right now is that it is underestimating inflation. Investors are sitting on securities providing a fixed coupon, which can sensibly reprice if there is an upside surprise in inflation. Within this context, nominal Treasuries are the worst investment one can hold on to as they do not provide any buffer for the real risks ahead of us.

How to gain exposure to Treasury Inflation-Protected Securities (TIPS)

You can trade select and trade various TIPS out of the Saxo platform. You can also select one of the ETFs available in the platform such as the below: