Inflation protection in a rising rate environment

Treasury in ation-protected securities (TIPS) are treasury bonds that have their notional value adjusted in line with realized in ation. They are therefore a convenient solution for investors seeking to preserve real purchasing power. Currently, 10-year TIPS are priced such that they will outperform nominal Treasuries if the realized in ation over the next 10 years exceeds on average 2.0% per annum. This 10-year breakeven in ation implied by TIPS is actually the same as the Federal Reserve’s in ation target. In other words, the market currently expects that the Fed will be able to keep in ation around its target over the next decade. However, the most recent January CPI reading for in ation is a bit higher at 2.5%. 

TIPS outperform nominal bonds when realized in ation exceeds expectations. The Citi In ation Surprise Index
for the United States, which measures in ation surprises relative to market surveys, is at its highest in more than
ve years, and the reading only turned positive in February. This means that the US in ation data came in higher than expected a er a ve-year period of persistent under- shooting (Figure 1). Investors who believe that positive in ation surprises (i.e. higher than expected) will be more frequent for months to come should prefer TIPS over nominal bonds. How likely is that to happen? On the one hand, political developments in the US with the potential for scal stimulus (along with near full employment) are likely to be supportive of price growth. On the other hand, the potential Fed interest rate hikes will have a muting e ect on in ation. The interplay between these two factors is likely to be key determinants of future in ation.