The March report on the U.S. Consumer Price Index didn’t paint the rosy picture some were expecting. Headline CPI year-over-year was 0.9% versus the expected 1% and core CPI ticked lower to 2.2% for the 12 months ended March, down from 2.3% in February. Despite this March surprise, we believe Treasury Inflation-Protected Securities (TIPS) can weather much more before they underperform nominal Treasuries.
Looking under the hood, the CPI weakness is mostly coming from an adjustment to the strong increase in core goods in January and February. Last month, we wrote that apparel’s surprising 1.6% increase in February was unlikely to be sustainable. In March, apparel was down 1.1%, giving back two-thirds of the gain.
But let’s step back for a minute. Core CPI is still running at 2.2% year-over-year; it was running at 2.4% annualized for the last six months and at 2.6% annualized for the last three. It is not exactly decelerating yet. At PIMCO, we expect core CPI and headline CPI to be running at 2% at the end of 2016 and in the coming years. This is still short of the Fed’s target of 2% in its preferred inflation measure, Personal Consumption Expenditures (PCE), which translates into 2.35% CPI. In February, we wrote that market signals are telling the Fed to run the economy “hot.” The Fed should be more comfortable with stronger inflation numbers than weaker ones, and the decision to pause in March reinforces this view.
What are the implications for portfolios? Well, valuations matter. The two-year inflation breakevens priced by April 2018 TIPS show TIPS outperforming nominals if inflation is above 1.42%. At these numbers, after extracting the risk from the volatile energy component the TIPS would still offer positive returns if core inflation is above 1.25%. – a whopping 95 basis points (bps) lower than current core inflation and 75 bps below our best case. TIPS are priced to weather a lot more bad news.
One concern investors express with TIPS has been the 10-year real yields now close to 0%. We’ve argued that low real yields are embodied in every asset class and are not specific to TIPS. We see these real yields as attractive compared with the negative real yields in most of the developed world, and they are consistent with PIMCO’s New Neutral thesis.