PIMCO's Worah: There May Be More Room for TIPS Outperformance

In the nearly two weeks since the U.S. presidential election, the 10-year breakeven inflation rate has risen, indicating that investors think it is now more likely that we will see higher inflation over the next 10 years.

The breakeven inflation rate, which is calculated by subtracting the yield on a 10-year Treasury Inflation-Protected Security from the yield on a 10-year nominal Treasury bond, jumped from 1.73% (on Nov. 8), to 1.83% (as of Nov. 16). What this means is if actual inflation exceeds the breakeven inflation rate over the holding period of the bond, the TIPS bond would provide superior returns to a similar-maturity conventional Treasury.

So, if you're buying a TIPS bond today, you are assuming that inflation would have to average at least 1.83% per year for the next 10 years, or else you would have done better to invest in a traditional Treasury bond. That's the difficult piece of the analysis: Is it a good bet that you'd come out ahead if you invested in TIPS at today's levels?

I recently asked Mihir Worah, PIMCO's CIO of Asset Allocation and Real Return, for his thoughts on where inflation is headed and current valuations in the TIPS market.

Wallace: How has PIMCO's inflation forecast changed, or not changed, post-election?

Worah: It has changed. From early in the year, we had a forecast for inflation moving up when most people had a forecast for inflation moving down. And it had been moving in our direction even before the election; we felt that inflation was more likely to move up modestly than to move down. Partly this is because we thought oil prices would move from the $30s to the $50s, which they did--but that's a short-term impact.

Longer term, the output gap in the U.S. was closing, the Fed was willing to let the economy run a little bit hot to make up for all the misses in the past, and we thought wages would start to rise after several years of stagnation, and we were seeing all of that before the election.

Post-election (while it’s hard to quantify because there is a lot of uncertainty in what, exactly, policies will be) our expectation is that longer term, inflation would move up even more than we expected before the election. There's two simple reasons for that. While we don't know exactly what policies will be in place, we think there will be a fiscal stimulus--either a tax cut or a corporate tax reform, and possibly even infrastructure spending--so to the extent that a fiscal stimulus adds to growth, there's some inflationary tilt to it. But here's the important point on the fiscal stimulus: We expect a fiscal stimulus coming from this administration, either tax reform or infrastructure spending or some combination of both. When the economy is weak and there is a large output gap, fiscal stimulus is good, [but] maybe the inflationary impacts are not that big. But right now, the output gap has pretty much closed, and we're running at a sub-5% unemployment rate, and wages are already starting to rise. So in this situation, when the economy is close to full employment, when you get an additional fiscal boost, that's likely to be more inflationary than otherwise.

And the second reason is, though we don't know the details, there's likely to be some kind of change in trade policy--global trade is likely to go down, there may be tariffs, protectionist measures. So if, say, everything the U.S. buys from Mexico, China, is going to have a 15% tariff on it, then that results in high expenses for Americans.

So, a combination of fiscal stimulus, importantly at a time when the economy is pretty close to full capacity, combined with possible protectionist trade measures, biased us to raise our inflation forecast from where it was before the elections.

Wallace: What are some risks to that forecast?

Worah: One risk is that we get neither a fiscal boost nor a protectionist trade policy. The second one is a longer-term issue, but [another risk is that] some of these policies are enacted, and either because of the policies themselves, or because of some external events, we end up in a recession. In a recession, demand drops off significantly, and inflation would go down.

The third risk, which is not so much a direct risk, but it's a factor that is countering this protectionism, is the fact that the dollar has been rising. A stronger dollar in terms of imports means cheaper prices for Americans. But if the U.S. dollar goes up 10% it has a 0.1%/0.2% impact on inflation. So generally, if you have a significantly strong dollar against collapsing global currency, that's on the margin a deflationary impact. We think the protectionism outweighs the deflationary [impact], but on the margin a stronger dollar is disinflationary for the U.S.

Wallace: To what extent are the valuations on TIPS reflecting the view of what the likely impact of inflation could be?

Worah: There's two ways to think about TIPS. One is, what are the inflation expectations embedded in TIPS? And, as an alpha trade, should you replace some of the Treasuries in your portfolio with TIPS, and will they outperform if inflation turns out to be higher than the inflation expectations embedded in the market? For example, that's what PIMCO does in many of its portfolios. So we started the year with 10-year inflation expectations around 1.5% per year for the next 10 years in the TIPS market. We thought those were too low, they were likely to move higher, so we replaced many of the Treasuries in our portfolios with TIPS. And we were right--inflation expectations had been moving higher even before the election. So we started the year at around 1.5% per year for the next 10 years, and before the elections we had gone up to about 1.75% per year for the next 10 years, so up about 25 basis points. Post-election, now the TIPS market is pricing about 1.95% per year for the next 10 years. So they've moved up even more post-election.

And we think there's more room. Nothing moves in a straight line, but if things go as we expect, then we think in six months from today those 10-year inflation expectations could be somewhere between 2.25% and 2.5% per year, which is where they've been historically, pre-crisis. So there is still room for TIPS outperformance. They were outperforming before the elections, they've outperformed some more after the elections, and there's probably still some room for outperformance.

So that's sort of a narrow view--inflation expectations are too low; they are going to move wider.

The bigger view--there's a very big change that sort of gets magnified post-election. [Regardless of whether you believe interest rates are going to go up or down], I think everyone should own government bonds in their portfolio. This is your safe, risk-free asset. You could have a view on interest rates, but for the money you're going to need in five years, for college, for a home, etc., you need government bonds in your portfolio. And now, with higher inflation more likely than lower inflation, I think it makes sense that the government bonds you own in your portfolio are TIPS. For the last three years, it probably made sense to own regular government bonds as your safe asset. In today's environment, especially post-election, it makes sense that the government bond portion of your portfolio should be in TIPS. So it's a big asset allocation shift, I think.

Wallace: You mentioned the liquidity of the TIPS market; how does the so-called liquidity premium factor into your analysis of TIPS valuations?

Worah: [TIPS are] less liquid than regular Treasuries, but they are Treasuries after all. And they're much, much more liquid than corporate bonds, etc. So we do look at the liquidity premium, and these are discussions we've had with the Fed a lot. We think for the last couple of years, liquidity in the TIPS market has been OK. There hasn't been much illiquidity. Yes, there is some illiquidity, and there should be a small liquidity premium, but it hasn't been much. One of the discussions we've been having with the Fed, and I think the elections, etc., proved that we're right, is that these inflation expectations were really low. These TIPS breakevens coming into the year they were 1.5% per year for the next 10 years, and the Fed would say these TIPS breakevens are low not because inflation expectations are low, but because there's a large liquidity premium in the TIPS market. And we'd argued that for a number of reasons, that's not correct. That liquidity in the TIPS market is OK. That breakevens are low because inflation expectations are low, not because of a liquidity premium.

And you can see after the elections, the fact that breakevens are wider, and there's been no change; in fact the [TIPS] market has been less liquid in these violent moves. There's been no change in liquidity, and yet, breakevens are wider. Which kind of confirms that while TIPS are less liquid than Treasuries, today there's not much of a liquidity premium. Breakevens were low mostly because inflation expectations were too low.

The views expressed in this article do not necessarily reflect the views of Morningstar.com. Some of the responses have been edited for clarity.