Inflation Angst Turns TIPS Into Must-Watch $1.6 Trillion Market

The U.S. is about to sell 10-year inflation-linked debt next week, keeping the spotlight on a corner of the bond market that’s rarely garnered this much attention in the almost quarter-century since its debut.

Heightened fears about the risk of raging consumer-price gains as growth rebounds are driving investors of all stripes to search for cover in Treasury Inflation-Protected Securities, a market that’s grown to $1.6 trillion. Traders talk of new entrants like retail buyers and global macro strategists -- what the veterans are dubbing the “tourist crowd.” Cash has also been flowing into the largest exchange-traded fund for TIPS, part of the rabid demand that’s driven inflation expectations over the next half-decade to a 16-year high.

It’s all adding up to a head-spinning stretch for inflation traders. They say they’ve been caught off guard by the burst of activity, and the speed with which last year’s pandemic-induced recession is giving way in some minds to 1970s-level angst over out-of-control inflation. Barclays Plc’s Chris McReynolds likens the volatility in TIPS pricing to “watching table tennis while sitting in the middle of the table.”

Inflation Angst Turns TIPS Into Must-Watch $1.6 Trillion Market

Leaving aside questions over whether TIPS are overstating inflation pressures, traders see opportunity at a time when forecasts for some key data, including consumer prices, have been way out of line with actual readings. Gang Hu, at hedge fund WinShore Capital Partners, says he’s seen many traders exit TIPS positions over much of this year as market-based inflation expectations climbed. He says Thursday’s $13 billion auction of inflation-linked debt will be seen as a key gauge of investor appetite and a possible opportunity for some to re-enter.

“Nobody actually has a very good handle on where near-term inflation prints will land, and it’s thrown everyone off their game,” said Hu, a managing partner at the New York-based fund. “There’s a lot of noise in the recent prints and this is not over yet. There’s no way anyone can be very confident about what the next two or three prints will bring.”

Fed Test

That’s spurring volatility in a part of the bond market that hasn’t typically seen such activity, with volumes swinging from week to week as above-estimate inflation readings test the Federal Reserve’s oft-repeated message that the pressure is likely to be temporary.

This past week, the five-year inflation outlook, or breakeven rate, jumped to 2.82%, the highest since 2005, after a bigger-than-expected surge in consumer prices for April. The 10-year nominal Treasury yield touched the highest in more than a month this week.

The signals from bonds have broad implications across markets. Stocks slumped by the most since February after the inflation data as traders pulled forward the timing for when they expect the Fed to lift rates, and a measure of consumer sentiment unexpectedly slumped this week. Fear of inflation is also driving a flurry of corporate issuance.

“We’ve obviously been through a lot in this part of the market in the last 14 months -- going from, ‘Wow, this pandemic is deflationary’ to ‘Oops, there’s inflation,’ ” said McReynolds, head of U.S. inflation trading at Barclays in New York. “What’s different in this episode is the crazy volatility, with investors going from hating TIPs to loving them, to hating them again. We are probably going to be here for at least a couple of years,” with volatility elevated around consumer-price data releases.

For much of its existence, the TIPS market has been a largely bearish one -- where traders were skeptical about the sustainability of any substantial price gains that did emerge. The few times that expectations did soar, they always retreated.

2008 Review

One example: in the lead-up to the 2008 financial crisis, when the 5-year breakeven rate shot up to 2.73% amid a housing boom and soaring oil prices. But the rate soon fell off and has largely stayed below that level since.

On Thursday, the New York Fed announced plans to reduce the amount of TIPS it will purchase over the next month. That tweak, along with Treasury’s previously stated plan to boost auctions of TIPS in coming quarters, may help alleviate any near-term shortage of the securities.

For WinShore’s Hu, who trades global inflation-protected securities, next week’s auction is a must-watch event. The last TIPS auction, on April 22, was a sale of 5-year securities for which investor demand was the strongest since 2019.

Hu says many traders are probably “waiting to see if they can buy something cheap” and currently trading in a zig-zag fashion -- purchasing TIPS when breakeven rates narrow and selling when inflation expectations go up.

“We are stuck in a negative feedback loop on inflation, and we could easily have 4%-5% inflation in a year’s time, way more than the market is pricing in,” he said. “We have to throw all our forecasting models for the next three to six months out the window.”

What to Watch

  • Economic calendar:
    • May 17: Empire manufacturing; NAHB housing data; TIC flows
    • May 18: Building permits; housing starts
    • May 19: MBA mortgage applications; Federal Open Market Committee minutes
    • May 20: Philadelphia Fed business outlook; jobless claims; Langer consumer comfort; leading index
    • May 21: Markit U.S. PMIs; existing home sales
  • Fed calendar:
    • May 17: Vice Chair Richard Clarida; Clarida with Atlanta Fed’s Raphael Bostic
    • May 18: Dallas Fed’s Robert Kaplan
    • May 19: St. Louis Fed’s James Bullard; Bostic interviewed at Businessweek/Bloomberg event; FOMC minutes
  • Auction schedule:
    • May 17: 13-, 26-week bills
    • May 18: 52-week bills; 42-day cash management bills
    • May 19: 20-year bonds
    • May 20: 4-, 8-week bills; 10-year TIPS reopening

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