Partner, Head of Fixed Income
Friday’s stronger-than-expected job numbers pushed nominal Treasury yields higher, with the 30-year benchmark Treasury approaching 5% YTM before moving lower on the day. Real yields (yields adjusted for inflation) also rose. Treasury inflation protection securities, or TIPS, yields for 10- and 30-year maturities hit 2.31% and 2.59% as of midday Friday, highs not seen since the global financial crisis of 2008-2009.
What Are TIPS Yields?
TIPS yields are indexed to inflation and as such can be viewed as a real rate of return. The equation below represents the relationship between real, nominal and inflation expectations for TIPS yields.TIPS Real Yields = Nominal Yields – Inflation
The current high level of TIPS yield reflects the move higher in nominal yields with less of a move higher in inflation expectations. Does this mean TIPS are attractive if real rates are so high? The answer to that depends on your view of future inflation. If inflation and inflation expectations continue to move higher, then TIPS will likely do better than nominal Treasuries. If inflation and inflation expectations decline, then you may be better off in nominal Treasuries. Other factors aside, this needs to be addressed before buying TIPS.
What Should Investors Expect To See From Real Yields In The Near Term?
Historically high real rates might indicate that long-end nominal Treasury rates are too restrictive—that is, too high for the current inflation expectations. If we expect real rates to move back in line with their historic average, then inflation expectations must rise and/or nominal yields must fall. In the few instances since 2003 when the 10-year TIPS yields approached 2.5% (green line), the subsequent decline in real yields (navy) was driven by an initial decline in nominal yields (orange).Certainly, an increase in inflation expectations (light blue) would also bring down current real rates to more average levels but given the recent hawkish stance from the Federal Reserve, it is more likely that nominal rates have risen too high and too fast in the near term. Of course, this time may be different and real rates could remain elevated for some time, but it would appear as if long-term nominal Treasury yields may be too high given the current inflation expectations.
