Investors Stash Cash in Treasury Inflation-Protected Securities
(Bloomberg View) -- Last month the bond market showed its greatest anxiety in almost a decade, after President Donald Trump signed a $1.5 trillion tax cut that benefits corporations and the richest Americans. The flow of funds into so-called TIPS, the Treasury Inflation-Protected Securities, reached a record in February -- a sign that investors are bracing for inflation.
TIPS were created in 1997 to ensure not a penny is lost when the cost of living suddenly spurts. The principal rises when the Consumer Price Index goes up. Early on, they didn't really have a chance to pay off. Starting in 1998, President Bill Clinton oversaw four successive budget surpluses (the only federal surpluses since Neil Armstrong walked on the moon). Inflation averaged a modest 2.6 percent during Clinton's two terms, less than half the 6.1 percent that unsettled investors between 1970 and 1992.
This newfangled debt instrument finally bore fruit after President George W. Bush cut taxes in 2001 and the government red ink returned with a vengeance. At the end of 2008, the budget deficit was 4.7 percent of GDP and the Consumer Price Index reached a 96-month high of 3.8 percent (inflation averaged 2.9 percent under Bush).
The previous peak in ardor for TIPS was in May 2012 during Barack Obama's presidency, when inflation averaged 1.6 percent.
The march to all-time highs for TIPS began last year with the growing prospect of Trump's tax cuts, which the nonpartisan Congressional Budget Office said will add $1.7 trillion to federal deficits during the next 10 years. Everyone from Federal Reserve Chairman Jerome H. Powell to the $1.75 trillion (total asset under management) Pacific Investment Management Co. says inflation shows no signs of roaring back. The U.S. Personal Consumption Expenditure index, the Fed's preferred measure of inflation, will rise to 2.1 percent in 2020 from 1.5 percent, according to 49 forecasts compiled by Bloomberg.
But TIPS have become the sanctuary for the once-ubiquitous "bond vigilantes" whom Clinton fretted about and disarmed by the time he left the White House. Those wary bondholders got their wish, as the ratio of debt held by the public to gross domestic product, a primary measure of U.S. federal debt, declined to 33.6 percent by 2000 from 47.8 percent in 1993 -- aided by a combination of spending cuts and raising taxes on the wealthiest 1.2 percent of Americans. The debt held by the public was reduced by $453 billion during the four years ending 2001, the only such occurrence of fiscal prudence between 1970 and 2016.
Real GDP growth under Clinton, during the longest expansion in U.S. history, averaged 3.8 percent, compared with 3.1 percent between 1970 and 1992. The number of people in poverty plummeted. The unemployment rate for African-Americans and Hispanics was the lowest on record. All of these favorable trends were reversed under Bush, when GDP grew annually at only 2.3 percent and when inflation and the budget deficit continued to climb. The wars in Afghanistan and Iraq were expensive, as were Bush's tax cuts.
Now the once-dormant inflation securities are rallying: the bond market's vehicle of foreboding. Last month, BlackRock's iShares TIPS ETF, already the largest exchange-traded fund tracking U.S. inflation, hit a new high with total assets of $25 billion, according to data compiled by Bloomberg.
As TIPS were surging, the Personal Consumption Expenditure Core Price Index hovered at 1.52 percent, which is 20 basis points below the 18-year average.
The unprecedented demand for TIPS, especially during the past year, helped make them the stars of the Treasury market. Since late 2015, when the Federal Reserve began raising interest rates for the first time in nine years as the economy recovered from the worst recession since the Great Depression, TIPS provided a total return (income plus appreciation) of 6 percent, quadruple the return from benchmark Treasury securities, according to the Bloomberg Barclays Indexes.
Why would investors show so much alarm by embracing TIPS when trader bets and the Fed's favorite measure of inflation showed nothing to get excited about?
The answer is we've seen this motion picture before, and it didn't end well. Since 2001 when the Bush tax cuts began and June 2006 when the Fed last raised interest rates before the financial crisis, the surplus (2.6 percent of GDP) turned into a 3.8 percent deficit. The unemployment rate, hovering near a 40-year low of 3.9 percent, climbed to 6.3 percent. The implied volatility of U.S. government bonds, a measure of investor uncertainty on the economy, increased 53 percent to 161 from 105. And inflation, measured by the Personal Consumption Expenditure index, quickened to 2.4 percent from 1.8 percent.
During this period when the financial system was hurtling toward the breaking point and the economy was deteriorating, TIPS proved superior, returning 49 percent when the rest of the Treasury market gained 28 percent, the Bloomberg Barclays Indexes show.
It's too early to say a similar period of turmoil is under way. The deficit has widened to 3.4 percent of GDP from 3.1 percent since the end of 2017, and the implied volatility of U.S. Treasury bonds surged 44 percent from the record low of November.
One thing is for sure: Investors already know where to put their money.
(With assistance from Shin Pei)
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Matthew A. Winkler is a Bloomberg View columnist. He is the editor-in-chief emeritus of Bloomberg News.
To contact the editor responsible for this story: Philip Gray at philipgray@bloomberg.net.
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