It may be time to add exposure to Treasury inflation-protected securities (TIPS), according to BlackRock’s global chief investment strategist.
In his weekly market commentary for BlackRock, Richard Turnill writes that a slowing but growing U.S. economy, coupled with a Federal Reserve on hold, should boost the appeal of inflation-linked U.S. bonds.
“We expect the Fed to hold off on any rate moves until at least the second half of 2019, after it pledged a more patient stance on policy,” Turnill writes. “Combined with still solid economic growth, this is likely to further weigh on both nominal and real yields.”
According to Turnill, this makes TIPS an attractive alternative to nominal bonds.
In addition, the Fed may let inflation temporarily breach its 2% target.
Turnill notes that Fed officials have also signaled they may be willing to allow for “modest overshoots” above the central bank’s inflation target to make up for past undershoots.
Bloomberg reported on Feb. 22 that two Federal Reserve officials — San Francisco Fed President Mary Daly and New York Fed President John Williams — recently highlighted the benefits of an approach to monetary policy called “average inflation targeting.” This approach, both Bloomberg and Turnill note, would involve accepting overshoots of the central bank’s 2% goal to make up for times when inflation was too low.
The two Fed presidents both mentioned the tactic during presentations at a conference in New York, according to Bloomberg.
At the time, Williams said that the “persistent undershoot of the Fed’s target risks undermining the 2% inflation anchor.” Daly noted that “inflation has been below our target” for a long time, according to Bloomberg.
According to Bloomberg, it’s expected that average inflation targeting would be among the options reviewed by the Fed this year.
This view of inflation is partly why Turnill favors TIPS.
“This could lead inflation-protected bonds to outperform their nominal counterparts — underlining our call for adding some TIPS exposure to portfolios at the expense of nominal bonds,” Turnill wrote.
Turnill sees TIPS performing well in this base case of a Fed pause and ongoing, albeit slower, global growth.
However, if the economy fares better than expected and the Fed raises rates sooner, Turnill thinks this scenario could also bode well for fixed income instruments indexed to inflation. This is because higher inflation expectations would likely be a critical driver of the Fed’s gear shift.
“Markets are pricing in a big undershoot of inflation versus the Fed’s target — as has been the case for much of the post-crisis period,” Turnill explains in the commentary. “The Fed’s favored gauge — which measures the expected inflation rate over the five-year period that starts five years from today — points to inflation of just above 1.8%.”
However, according to Turnill, the recent change in the Fed’s commentary around inflation suggests the central bank would “likely want to see inflation slightly exceed its target before considering a resumption of policy tightening – for fear of choking off economic growth.”
Turnill does look at the case against inflation-protected securities within a fixed income portfolio. According to Turnill, the risk would be a renewed spike in U.S. recession fears, as well as growing market expectations that the Fed may cut rates.
“TIPS would likely underperform nominal bonds in such a scenario, although we would still anticipate positive absolute returns,” he writes.
Turnill sees this scenario as unlikely in 2019, given the strength of the U.S. economy.