If future inflation equals the breakeven rate, then an investment into a 10 year Treasury and a 10 year TIP would have roughly the same return. Thus it is the level of inflation that makes the two investments break even. There are several directions you can take, depending on your view of inflation:
- If you’re bullish on inflation, you might prefer TIPS. That’s because you could benefit if inflation exceeds the breakeven rate. In this case you could use a fund like the iShares TIPS Bond ETF (TIP) to get exposure to the broad TIPS curve.
- If you’re bearish, and believe inflation will end up below the breakeven rate, then you might prefer Treasuries. Here a fund like the iShares Core U.S. Treasury Bond ETF (GOVT) may be appropriate.
- If you want to position for inflation but want to manage interest rate risk, then you could use funds like the iShares 0-5 Year TIPS Bond ETF (STIP) for TIPS exposure and the iShares 1-3 Year Treasury Bond ETF (SHY) for Treasury exposure.
So how will the inflation story play out? Right now recent declines in realized inflation (as measured by the CPI) have led investors to expect lower rates of inflation in the US in the coming years. This is consistent with declining growth and inflation that we are seeing in other markets (most notably in Europe). Whether or not this stays the Fed’s hand and keeps short term interest rates low is yet to be seen. For now, movements in inflation expectations are a key indicator to watch when considering the Fed’s next move.
*Source: Bloomberg
Matthew Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to The Blog. You can find more of his posts here.