SCHP - Riding The TIPS Rollercoaster: SCHP's Bumpy Journey Towards A Potential Rebound

2023-07-04 02:38:06 ET

Summary

• SCHP had a bumpy ride since late 2021 due to rising inflation and interest rates; however, current levels suggest a potential bottom.
• High real rates, decreasing inflation, and inflation volatility are expected to support a rise in SCHP over the next 6 to 9 months.
• The downward trend in commodities, particularly gold, and the potential resolution of the Ukraine conflict could also positively impact SCHP.

Investment Thesis

The Schwab U.S. TIPS ETF ( SCHP ) has faced a challenging 2022 in the face of high inflation and aggressive monetary tightening, but now shows potential for a rebound. Recent support at current levels and the absence of new lows despite hawkish rhetoric and high CPI numbers suggest a bottom may be forming. With SCHP far from overbought territory, the recent sell-off presents an attractive entry point in my opinion for the bulls. Notably, real rates are at a decade high while SCHP is at a decade low, indicating an opportunity to buy bonds in a market that seems to be stretched to the downside. Decreasing inflation, along with high real yields, supports a move higher for SCHP in the next 6 to 9 months.

About SCHP

SCHP is designed to track the performance of the B loomberg US Treasury Inflation-Linked Bond Index. The strategy seeks to provide investors with a reliable hedge against rising inflation. By investing primarily in TIPS, which are U.S. Treasury securities designed to adjust their principal value in response to changes in the Consumer Price Index ((CPI)), the fund aims to preserve the purchasing power of investors' capital in inflationary environments. This strategy can prove particularly valuable during times when inflation threatens to erode the real value of traditional fixed-income investments.

When it comes to its holdings, SCHP provides exposure to a wide range of TIPS issued by the U.S. government. These securities, backed by the full faith and credit of the U.S. Treasury, offer investors a reliable and low-risk avenue for participating in inflation-protected fixed-income markets. By investing in SCHP, individuals gain access to a diversified portfolio of TIPS across various maturities, thereby spreading their inflation protection across a range of durations.

For further data on SCHP, please check the fund's prospectus .

SCHP's Resilience and the Potential Rebound

US Treasury Inflation-Protected Securities ((TIPS)) have faced considerable challenges since late 2021, as inflation began to rise alongside a rapid increase in interest rates. This led to a loss of over $10 per share for SCHP. However, I am now seeing significant support at current levels, potentially signaling a bottom. Despite the hawkish discourse from the Federal Reserve and other central banks, as well as relatively high CPI numbers, SCHP has failed to make new lows recently. Additionally, SCHP is far from overbought, making the recent sell-off an appealing entry point for bullish investors.

An intriguing divergence can be seen between inflation expectations and real yields. Purple on the chart below represents real rates calculated using US 10-year yields versus 5-year inflation swaps. Currently, we are witnessing the highest real rates in the past decade, while SCHP is at a decade low. Interestingly, we saw the opposite dynamics play out during 2020-2021, leading to a significant reversal. Given the current inflation dynamics, there is a genuine incentive to buy bonds in this market, as lower real rates tend to stay high for a limited period. A downward move in real rates would certainly benefit SCHP.

Multiple government and alternative data sources indicate a decline in inflation in recent months, accompanied by lower inflation volatility. These factors contribute to a smoother path toward achieving the 2% CPI target. With Fed Funds at over 5% and CPI approaching 3%, SCHP is well positioned to benefit from these tailwinds.

Commodities have been key drivers of inflation throughout the cycle, but we are currently observing a notable downward trend in the Bloomberg Commodity Index (BCOM). Many constituents within BCOM are experiencing a downtrend, with gold being particularly significant as it remains near its all-time high. However, I anticipate that gold will follow suit in the coming months and embark on its own downward trajectory.

While it may be premature, I am closely monitoring the situation in Ukraine, and recent developments in the bond market are encouraging. The chart below illustrates the Ukrainian 3-year yield, showing an accelerated downtrend since Q1 2023. This suggests that the market may begin to price in a resolution to the conflict. Should this trend persist with its current momentum, we may soon hear news about peace talks. In my opinion, this has a bearish impact on commodities, especially gold, which has served as a safe haven during this conflict.

Overall, decreasing inflation and inflation volatility, combined with decade-high real yields, create a favorable environment for SCHP to move higher. In terms of timing, I anticipate this upward movement to gain traction within the next three months, extending over the following 6 to 9 months.

Key Takeaways

The recent support at current levels and the absence of new lows, despite hawkish rhetoric and high CPI numbers, indicate a possible formation of a bottom for SCHP. With SCHP remaining far from overbought, the recent sell-off appears to be an appealing opportunity for bullish investors. Notably, real rates are at their highest in a decade, while SCHP is at a decade low. The combination of declining inflation and elevated real yields supports the expectation of SCHP moving higher within the next 6 to 9 months.

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