Regardless of Inflation Spikes Caused by Tax Cuts and Budget Battles, These Bonds Will Continue to Perform

Treasury Inflation-Protected Securities (TIPS) could outperform traditional, nominal U.S. Treasurys if inflation expectations continue to rise beyond current levels. That’s why investors focused on inflation trends may find value in shifting some of their fixed-income exposure toward TIPS, especially if several potential catalysts push inflation expectations higher.

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TIPS are bonds issued by the U.S. Treasury that adjust with inflation, offering protection against the erosion of purchasing power. Unlike nominal Treasurys, TIPS guarantee a return above the inflation rate if held to maturity. This makes them particularly attractive during periods of rising inflation expectations.

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Several global and domestic developments could boost inflation expectations, thereby benefiting TIPS. These include the possibility of an escalating trade war, increased federal spending following the recent House-approved bill that expands the federal deficit, the potential repercussions of Moody’s downgrade of the U.S. credit rating, and the likelihood that foreign central banks may sell U.S. debt or reduce their holdings of U.S. dollars in favor of other currencies.

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Should any of these factors materialize, inflation expectations could spike. In such a scenario, investors may want to allocate more of their fixed-income portfolio to TIPS. One straightforward way to do this is by purchasing the iShares TIPS Bond ETF (ticker: TIP).

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For those seeking a more sophisticated strategy, another option is to simultaneously buy the TIP ETF and short an equivalent dollar amount of the iShares 7-10 Year Treasury Bond ETF (ticker: IEF). This paired trade effectively isolates inflation expectations by offsetting the interest rate exposure of nominal Treasurys.

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It may seem counterintuitive to actively trade TIPS, since they are designed to be held to maturity, providing a fixed real (inflation-adjusted) return. However, market behavior shows that investor sentiment toward inflation drives significant flows in and out of TIPS ETFs.

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For instance, over the past five years, an average of $784 million has moved monthly in or out of the TIP ETF, amounting to more than 3% of the fund’s total assets under management. These movements indicate that many investors trade TIPS based on short-term inflation outlooks, not just long-term hold strategies.

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Historical data supports the link between changes in inflation expectations and TIPS performance. A study that grouped monthly changes in five-year inflation expectations—using data from a model by the Cleveland Federal Reserve—found a strong correlation between rising inflation expectations and TIPS outperformance relative to nominal Treasurys. Specifically, the return difference between the TIP and IEF ETFs widened when inflation expectations increased.

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This correlation is statistically significant at the 95% confidence level, meaning there’s strong evidence that higher inflation expectations lead to better performance by TIPS. However, successfully trading TIPS based on this pattern is still challenging. Predicting shifts in inflation expectations is complex, and even if your forecast is accurate, you must act ahead of the broader market to benefit financially. Given these challenges, some investors might prefer to buy and hold TIPS, especially now, when yields are relatively high.

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Currently, TIPS yields are well above their long-term averages, making now a potentially favorable entry point for long-term investors. The yield on the 10-year TIPS, for example, is at 2.16% — more than twice its average since 2003. While ETFs like TIP don’t have a set maturity date, investors who buy a 10-year TIPS bond and hold it until maturity are guaranteed a real return of 2.16% annually over the next decade, regardless of how high inflation rises.

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This fixed return over inflation is appealing, particularly in an environment where inflation uncertainty remains elevated. For investors seeking a hedge against future price increases, TIPS offer not only protection but also the potential for gains if inflation expectations surge.

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In conclusion, while trading TIPS based on inflation forecasts can be difficult and is not without risk, the asset class presents compelling advantages in today’s economic climate. With inflation concerns still in play and TIPS yields well above historical norms, now may be an opportune moment for investors to consider TIPS as either a strategic trade or a long-term inflation hedge.

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