Rewind a few months to the middle of December. Oil was dropping below $60/barrel and many market observers wondered whether deflation – or the “D” word – was back. TIPS, or Treasury Inflation-Protected Securities, seemed to them like a losing wager if a significant rise in U.S. inflation was such a long shot.
A closer look at the numbers tells a different story about TIPS. Breakeven inflation (BEI) for 10-year TIPS over 10-year Treasuries had dropped to 1.6% in mid-December: This meant that for TIPS to outperform regular Treasuries of the same maturity, inflation had to run above 1.6% for the next 10 years – maybe not such a long shot, after all. PIMCO’s view was that it was unlikely the Fed would miss its 2% inflation target by 75 basis points (bps) for an entire decade (math check: TIPS are indexed to CPI while the Fed’s target 2% inflation is measured by PCE, which runs 35 bps under CPI). TIPS were, in our opinion, unusually attractive, and we believed the market was wrongly extrapolating December’s weak inflation into the future.
Fast forward and oil is back above $60, core CPI has been running at an annualized rate of 2.25% for the past three months and demand for TIPS is running strong. Ten-year BEI is above 1.9%. This may make TIPS a bit less attractive than they were in December, but make no mistake, they are still attractive. A tight labor market, rising wages and a Fed that remains cautious are all supportive factors for TIPS. We expect headline CPI to be near 2% one year from now (versus the 1.4% priced by the BEI rate for 1-year TIPS). This would help 10-year BEI to rise closer to 2.35% – still fair for TIPS, in our view.