Sparked by a global collapse in activity in response to the Coronavirus pandemic, the increase in volatility and resulting market dislocations have created investment opportunities (and risks) that bond markets haven’t seen in more than a decade. Treasury Inflation Protected Securities (TIPS), alongside many other fixed-income sectors, were hit hard by a series of negative fundamental and technical catalysts.
Treasury market dislocations
The world’s “risk-free” asset, U.S. Treasuries, experienced substantial market dislocations during this period. Dealer balance sheets became clogged with off-the-run Treasuries, as margin calls, exchange margin hikes, and repo scarcity prompted a rapid deleveraging process. Combined with stricter bank capital rules today versus ten years ago, market-makers were unable to effectively intermediate trading activity. And TIPS were not immune to the deterioration in market function. Further, break-evens fell sharply, and off-the-run TIPS cheapened in dramatic fashion relative to recently issued TIPS. They also under-performed nominal Treasuries of late.
In response to this situation, the Federal Reserve has acted in an unprecedentedly swift and aggressive manner to counter these dislocations, and while markets haven’t fully returned to normal, the central bank’s efforts are having great effect. Over the five weeks to April 15, the Fed purchased more than $1.2 trillion in Treasury securities across the curve, including $83 billion in TIPS. These massive purchases helped to clean up dealer balance sheets and restore market function (see graph).
Market liquidity dries up, just as demand sharply increases
The TIPS market is about 8.5% of the outstanding value of the U.S. Treasury market, and its smaller size and unique risk characteristics have always demanded a “liquidity discount” that increases in times of extreme market stress. The well-known formula for TIPS break-even inflation, or the amount of realized inflation that equates returns on Treasuries and TIPS, can be expanded to account for this liquidity discount. Recently, markets saw an extreme increase in the demand for liquidity, as precautionary cash raising soared and risk aversion increased. This activity led to a sharp deterioration in market liquidity, causing liquidity discounts to expand substantially. As such, nominal yields fell dramatically relative to TIPS yields, resulting in a sharp contraction in break-even inflation rates and an under-performance of the TIPS market.
Additionally, we must recall that TIPS principle amounts are indexed to headline inflation, and as such TIPS performance is sensitive to energy prices, specifically, the price of retail gasoline, which is generally between 3% and 4% of the headline CPI index. As countries across the globe have locked down their economies and implemented social distancing to combat the spread of Coronavirus, oil demand has plummeted. Simultaneously, a feud between two of the world’s largest oil producers, Saudi Arabia and Russia, had seemed to limit the possibility of a supply response to offset declines in demand. Ultimately, OPEC and other major producers did agree on a significant cut to production, but its influence on the oil price may be modest.
In addition to liquidity considerations mentioned above, TIPS break-evens are sensitive to credit spreads and measures of expected volatility. Indeed, several measures of market risk premium have also risen dramatically, in response to a fundamental increase in economic risk. Jobless claims, one of the best high frequency indicators of economic activity, have increased dramatically in recent weeks. Even though core inflation has been relatively stable, it is not immune to economic disruption. Traditional demand shocks have relatively straightforward transmission mechanisms to realized inflation. Reduced demand should reduce the price to equilibrate supply, all else equal.
TIPS Market Opportunities
Increased risk-aversion and market dislocations have given rise to alpha opportunities in the TIPS market. Here are three primary areas of investment opportunity:
- Liquidity deterioration has given rise to substantial cheapening of off-the-run TIPS, creating opportunities to go overweight cheaper, less liquid securities in the TIPS index, and underweight richer, more liquid securities. Dispersion across the break-even curve is the highest in the past decade, increasing relative value opportunities. Still, the Fed’s aggressive balance sheet expansion should support off-the-run sectors going forward.
- In the front end of the inflation curve, which is most sensitive to energy price fluctuations due to its short duration, inflation expectations have declined, in our estimation, in excess of what energy price declines would suggest, making it a fundamentally cheap asset.
- Lastly, given the quantity of monetary and fiscal support in the pipeline, we think real rates have room to move lower. TIPS provide targeted exposure to the expected real interest rate. The Fed, so far, has been reluctant to embrace the use of negative nominal interest rates. Without negative rates, nominals have less price appreciation potential, but real rates still have substantial upside.
Fiscal and monetary support
In our view, the response to the Coronavirus pandemic creates a sharp negative fundamental shock to the global economy, but the shock should also be a temporary one. The duration of economic disruption is highly uncertain, and this uncertainty is the primary source of market angst, currently. To help bridge the gap in economic activity, policy makers have reacted swiftly and aggressively. The $2 trillion Coronavirus Aid, Relief, and Economic Security (CARES) Act provides substantial economic support. The Fed, alongside other global central banks, in two swift steps cut interest rates to zero and rolled out a host of crisis era financing programs to support financial market functioning. We expect the Fed to continue to increase its balance sheet, helping offset issuance due to fiscal support. In our view, this policy support creates a substantial safety net that dulls the extreme “left tail” risk in financial markets.
David Rogal, Managing Director, is a portfolio manager in the Multi-Sector Mutual Fund team within BlackRock’s Global Fixed Income Group. Bob Miller, Managing Director, is head of Americas Fundamental Fixed Income within BlackRock’s Global Fixed Income group and is a member of the Global Fixed Income Executive Committee.