TIPS Breakeven Curve Ripe to Steepen
Ben Breitholtz, Data Scientist at Arbor Research & Trading, LLC and Bianco Research, LLC, provides reasons for a steeper TIPS breakeven curve in the weeks and months ahead.
- Bloomberg – Bond Market’s Inflation Widowmaker Returns in a First Since 2013
In a rush to purchase inflation protection, bond traders are piling into wagers they already know will probably backfire on them. The demand for Treasury Inflation Protected Securities, known as TIPS, and the relentless flattening of the U.S. yield curve have sent the spread between 30- and 10-year breakeven rates below zero for the first time since 2013. When it turns negative, it’s colloquially referred to as a “widowmaker” trade, because it’s seen as likely to cause quick and sharp losses. Indeed, the last time it happened, the gap widened by more than 25 basis points within three months as the 2013 selloff known as the taper tantrum gripped bond markets.
Investors are beginning to shift flows from short-term to more long-term TIPS. The abrupt rise in WTI crude oil ($63.43) helped fuel demand for short-end inflation protection, but a more lasting need is being seen with broad and 5+ year TIPS ETFs accruing nearly $1 billion in flows over the prior 20 trading days.
TIPS investors know a favorable seasonal begins in January with U.S. 10-year TIPS breakevens widening a median of 8.7 bps. This seasonal tailwind persists through April before turning deeply negative in June.
Nonetheless, the TIPS breakeven curve remains extremely flat as investors have been apprehensive to drive long-run inflation expectations higher. The 10-year 30-year breakeven spread recently dipped below 0 bps, which has been a firm lower-bound since late 2000. The TIPS breakeven curve (see spreads in the chart below) since early 2016 has seen muted volatility compared to years past.
We employ the variables below to generate probabilities the TIPS breakeven curve will steepen over the ensuing 90 trading days:
• Global fund flows
• US 10-year term premium
• US 10-year Treasury implied volatility
• WTI crude oil
• Economic data changes
• Breakeven spreads
The second panel in the chart below shows the average probability the TIPS breakeven curve will steepen has increased to 69%. Similar breaks above a 50% probability the curve will steepen have coincided with or preceded each steepening cycle since 2010.
The next chart shows the probability of steepening over the following 90 trading days for each TIPS breakeven spread comprising the average shown in the chart above. The 2-year 5-year and 2-year 10-year are showing the most promise to rebound at 96% and 95%, respectively. The more long-term 5-year 10-year, 5-year 30-year, and 10-year 30-year are beginning to join the chorus.
Wage growth remains the painfully obvious missing link to a rising inflation premium at the long-end of the curve. But, some indications of hope are rising like the compensation index extracted from NFIB’s latest small business survey reaching its highest since March 2003.
The chart below shows headline (red) and core (blue) year-over-year CPI along with their spread (bottom panel). Rising headline inflation cycles are shaded in yellow.
Since 1970 headline CPI has exceed core during 74% of months by a median of 51 bps during these rising inflation cycles. Therefore, the Fed’s 2.0% target for core inflation is near 2.5% for headline inflation. This 2.5% threshold is important since we can use options on inflation (caps and floors) to determine the odds markets are placing on the Fed achieving its inflation target.
The chart below shows our preferred metric of inflation expectations, options on CPI. Each line represents the ratio between inflation swap caps (calls) versus floors (puts) by maturity with strikes at 2.5% year-over-year CPI. Again, we are assuming headline inflation will need to run at or above 2.5% to produce core inflation at or above 2.0%.
This ratio essentially offers the odds headline inflation will run above 2.5% year-over-year during each respective maturity. These inflation expectations are rising at the fastest pace since November 2016 when the 10-year TIPS breakeven last punched above 200 bps. We ultimately are looking for these odds of 2.5% headline inflation to surpass their early 2017 peaks shown in the chart below. This eventual break will be potentially one of the biggest game-changers for the dynamic of fund flows between risk and safe assets.