In November 2021, US annual inflation surged to 6.8%, the highest in 40 years. At the same time, US real yields on Treasury Inflation-Protected Security (TIPS) remained at record low levels for most of 2021, with the yield of the 10-year TIPS hovering around -1.0%.
Investors have tried to decipher the message behind deeply negative real yields and wonder if real yields could increase materially in 2022. Less negative, or even positive, real yields could have consequences for a broad set of assets.
As investors try to read the market tea leaves, these record low real yields also directly influence US break-even inflation, the difference between yields of nominal and inflation-protected US Treasury securities. This is commonly used as a proxy for market based inflation expectations. Lower real yields lead to higher break-even inflation, all else being equal, and vice-versa.
US 10-year breakeven inflation now stands at 2.5%, the highest level for more than a decade. The big question is whether a supply and demand imbalance in the TIPS market could be giving a misleading inflation outlook, with true inflation expectations being more muted than current market pricing might suggest.
There are good reasons to think this imbalance may start to unwind in 2022, putting upward pressure on real yields and downward pressure on break-even inflation. This matters not just for the signals we try to read from market pricing, but also the many asset classes which have benefitted from the low real yield environment in recent years.
Lower supply meets higher demand
To understand the reasons behind deeply negative US real yields, we first need to look at the supply and demand balance of TIPS. Since February 2020, the Federal Reserve (Fed) has purchased $244 billion of TIPS, taking its holdings to $375 billion, as of end of November 2021.
Consequently, the Fed’s share in TIPS market has increased from 8% in 2019 to 22%. This is less than the 25% the Fed owns of the broad Treasury market but, when seen through a different lens, the impact has arguably been even more pronounced in TIPS.
Since 2019, the stock of outstanding TIPS has increased by $188 billion. This means that the supply of TIPS net of Fed purchases has actually decreased by $56 billion. In the broad Treasury market, the stock of Treasuries has increased by $5.5 trillion, far outpacing the Fed’s purchases of $3 trillion.
On the remainder of the demand side, there have been some equally important developments. While the supply of TIPS net of Fed purchases has decreased, the demand for TIPS has increased significantly over the last year and a half.
This is evident when looking at the assets of US inflation-protected mutual funds and exchange-traded funds (ETFs). Since May 2020, the net assets of these funds have increased by $110 billion to $287 billion. Given that the TIPS market has returned 16% over this period, the majority of this increase has been driven by new inflows from investors. The net assets of the largest TIPS ETF have alone risen to $37 billion, making it the seventh largest US bond ETF.
With inflation being a top concern for most investors, it is perhaps not surprising that many have been looking for ways to shield their portfolios from rising prices. By design, TIPS provide the most direct hedge of inflation, as the principals and coupons of TIPS are regularly adjusted for annual inflation.
Besides the inflation compensation aspect, the prices of TIPS, like any other bonds, are sensitive to movements in yields. Hence, falling real yields directly benefit investors of these bonds.
This is reflected in the performance of nominal and real US Treasuries since 2019. The latter have outperformed the former by a wide margin. In 2021, the aggregate US Treasury index lost 2.4%, whereas the TIPS Index gained 8.3%.
In short, the Fed’s purchases and excessive demand could have weighed on real yields, pushing them lower than they perhaps otherwise would be.
Negative liquidity premium in TIPS
How big is the impact of supply and demand mismatch? The Fed publishes a model which aims to precisely measure that. The model breaks down the 10 year break-even inflation rate, called here ‘TIPS inflation compensation’, into three components:
TIPS inflation compensation = expected inflation + inflation risk premium – TIPS liquidity premium.
Historically, inflation risk premium, the extra compensation nominal bond investors demand for bearing inflation risk, has been positive (see figure below).
Granted, it has fallen over time, as investors have grown less worried about inflation and more confident in the Fed’s ability to manage it, but has picked up a bit recently.
TIPS liquidity premium, on the hand, is not directly related to inflation. The premium originates from inferior liquidity of TIPS compared to nominal Treasuries. In normal circumstances this is a positive figure. This aspect of TIPS became very acute in the financial crisis when a rising liquidity premium sent nominal and real yields in the opposite direction.
Like in 2008, the liquidity premium increased once again in March 2020, but the forceful actions by the Fed brought it swiftly down. It has been grinding lower ever since, and is now close to -0.7%, as seen in the figure below.
Here might lie the answer for the combination of red hot inflation and record low real yields: reduced supply of TIPS and greater demand for inflation-linked products has resulted in a large negative liquidity premium.
In this feedback loop, investors flock into TIPS, which will depress real yields and result in higher break-even inflation. The latter is then interpreted as a sign of rising inflation expectations, leading to even more money flowing into TIPS. And the cycle repeats.
The negative liquidity premium has two major implications. First, real yields are perhaps more depressed than they would be without the supply and demand imbalance. For example, assuming a zero liquidity premium, US 10 year real yield would be at -0.3%, not -1.0%.
Second, marked based inflation expectations, after taking account of the negative liquidity premium, could actually be lower than what is priced in by TIPS break-even inflation. The green line shows that while the “clean” 10-year inflation expectation has risen, it is still below the pre-Covid level.
The coming shift in supply and demand of TIPS
Looking ahead, the supply and demand balance of TIPS is likely to experience a significant shift in 2022. First, the Fed has started winding down its asset purchases programme. The tapering, which includes TIPS, commenced in November, and according to the latest Federal Open Market Committee (FOMC) statement, could be finished by April 2022.
At the same time that the Fed is scaling back its purchases, the supply of TIPS is moving in the opposite direction. The US Treasury wants to increase the share of TIPS in total Treasury debt from its current level of 7.5% up to 9.0%, back to its pre-pandemic level. An important consequence is that, even though the overall Treasury issuance is forecast to fall in 2022, TIPS issuance is not.
The net effect of these changes is that the net issuance of TIPS is likely to rise well above the Fed’s purchases in 2022. Could demand from other (non-Fed) buyers keep up with the increased supply? It is certainly possible, however, should the feedback loop described previously reverse, demand for TIPS could decrease, rather than increase.
As we showed above, flows into inflation linked funds are sensitive to movements in real yields. Periods of rising real yields and poor performance from TIPS can lead to outflows from the asset class. This happened in 2013. After years of steady inflows, the assets of US inflation-protected funds fell by 50%, as rising real yields drove investors out of TIPS.
Implications for investors
In sum, the supply and demand imbalance in the TIPS market has likely depressed real yields, although the full extent is not clear. Even the model estimates, highlighted above, will carry some uncertainty.
Nonetheless, real yields could move higher in 2022 as the Fed wraps up its asset purchases. In this scenario, nominal Treasuries could outperform TIPS.