STIP - STIP: Priced For Belligerent Inflation But Not Fed Action

2023-08-01 09:19:16 ET

Summary

• Based on the real yields from TIPS, they are already being priced for belligerent inflation, which should definitely concern equity investors.
• However, it also means that there probably isn't that much upside in the current real yields. In fact, Fed action is likely, and that isn't great for STIP.
• It's a pass, but also signals a reason to be cautious about equity markets.

The iShares 0-5 Year TIPS Bond ETF ( STIP ) tells us a lot of important information about inflation rate expectations. In short, STIP contains TIPS that are valued, acknowledging belligerent inflation. Moreover, it tells us that investors should take a general look at fixed income or equity markets outside the US since bond markets expect inflation to be belligerently above the 2% target for some years. STIP is not more than a hold; US equity markets are underweight as far as our opinion is concerned.

STIP Breakdown

STIP contains TIPS with a 2.5-year average effective duration. TIPS face values are indexed to inflation as well as their coupons at a constant rate on face value. They are made from Treasuries and therefore are considered to have zero credit risk. Their real returns are guaranteed, and speculators profit by buying them when expectations are too low for inflation and therefore trade at a premium that is too small from non-indexed Treasuries of similar duration. The S/D dynamics of these instruments affect the yield, which also tells us how zero credit risk instruments' markets peg inflation rate forecasts. The real yields are around 2.5% for TIPS with a 2.5-year duration, and the real yields are based on what newly priced TIPS would yield when released to the primary markets today. Inflation expectations till their maturity are baked in to these auctions. We don't use the given real yield figure by iShares because we are not sure where they get their inflation comparison from.

Considering the current yield curve , the 2-year rate and the 3-year are 4.9% and 4.5%, respectively. With STIP being around 2.5 years in average duration, that means that TIPS markets don't expect inflation to fall below 2% till somewhere between 2-3 (or even more) years from now. That's not what the Fed has in mind, to be sure, given past FOMC comments which were clear that the level as well as the pace of the inflation declines were critical for making sure inflation expectations don't de-anchor.

In some respects we agree with the TIPS markets, since a lot of the inflation declines right now are from resolving supply chain effects, at least those that could organically be resolved, as well as from more apples-to-apples comps with a post-Ukraine invasion environment. The last leg of inflation is from the actual propagation of price increases by all sorts of actors getting greedy in the economic machine. The only way to counter that greed is for there to be a recession where price hiking isn't negotiable - not easy.

This is where we might be disagreeing with TIPS markets, which possibly are at a consensus where they believe that the Fed will relax the target or two years is short enough for inflation to relax without further rate hikes. TIPS still suffer when rates rise, but they don't suffer if there is commensurate inflation. It's not great for TIPS if rates rise to take down inflation below implied expectations. It's strange that TIPS markets aren't pricing in the Fed hitting their target sooner, likely with further rate hikes. Real yields should be implied at higher rates given our view on the economy.

Bottom Line

TIPS markets signal that bond markets are considering a slow pace of inflation decline, and are pricing real yields with inflation expectations being higher in the coming years than the 2% target. We think further hikes will challenge the real yields and drive STIP lower. We are personally not convinced by what seems to be an implied expectation of a more relaxed rate action but higher inflation for a little while longer. Some may be ready for that, and then it's a hold. We are passing on STIP but also US equity markets, which we believe are generally at odds with expectations in the bond markets, which are always more sophisticated since it's tough for retail investors to get involved. Inflation is likely to be belligerent in this last 1% dash, and equity markets will suffer for it, as would STIP.

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