The sharp rise in short-term interest rates has significantly impacted financial markets and the economy at large since 2022. Since then, the extent and speed of interest rate hikes have no precedent in recent economic history. Despite that, core inflation has only seen a slight decline, and while the economy has slowed, there has not yet been an official recession or a sharp rise in unemployment. Further, the bulk of the declines in inflation is attributable to the drop in many commodity prices; should crude oil and similar commodities fall back into a shortage, inflation may surprise the upside.
In general, I would avoid long-term fixed-rate bonds in the current market because they pay a low return compared to inflation and could fall dramatically should inflation fail to decline as much as many expect. However, on the other end of the spectrum, short-term inflation-indexed bonds may be attractive, paying higher returns with superior inflation protection than long-term bonds. In early 2022, I was bearish on these assets because the rising interest rate outlook appeared to be a significant potential catalyst for market volatility. In general, that view has proven correct; however, the market has been far quieter since the fall of 2022 than I had anticipated. Since real short-term interest rates likely have the most significant immediate impact on market volatility, I believe short-term inflation-indexed bonds are due for a significant move over the coming months.
Investors can allocate toward these bonds through ETFs like the Vanguard Short-Term Inflation-Protected Securities Index Fund ETF Shares (NASDAQ:VTIP). VTIP owns “inflation-indexed” Treasury bonds with an effective maturity of 2.6 years. The real yield on these assets is currently around 2.75% (based on an equivalent fund), meaning it will pay a 2.75% yield plus the annual CPI inflation rate. For example, the current US inflation rate is 4%, so VTIP’s total yield is around 6.75% today, far higher than returns found in most bonds with essentially no credit risk and limited duration risk. I believe VTIP may be one of the best assets today, mainly because it will likely rise in value if the yield curve begins to re-steepen. That said, precarious market dynamics may cause VTIP to face additional downside, particularly if liquidity conditions continue to tighten.
The Case For an Inflationary Recession
Fundamentally, VTIP is neutral to inflation, with its value tied to the consumer price index, unlike other Treasury bonds. However, it is indirectly exposed to inflation because the Federal Reserve generally must increase interest rates above inflation to slow the economy sufficiently to lower inflation. The high 2.75% real return in VTIP today is a sign that the Federal Reserve is aggressively fighting inflation; however, it is also a sign that inflation is expected to decline over the coming two years. Inflation is 4% today but is expected to average 2.2% over the next five years and 2.15% over the next ten years. Importantly, these metrics are closely tied to the price of crude oil. See below:
The importance of crude oil and energy commodities, in general, seems to be understated, while the impact of the Federal Reserve may be overstated. In the past, tightening or loosening financial conditions had an immediate and significant impact on inflation by altering bank investment flows into physical capital (factories, etc.). Today, few companies are pursuing significant domestic output growth, and over recent decades most goods production has shifted abroad. Accordingly, the primary driver of goods prices is transportation costs, making crude oil an increasingly significant driver of inflation.
Overall, CPI inflation has fallen in half (or around 4%) since 2022, but core inflation, which excludes energy and food prices, has only declined by about 1%. Even then, core inflation is still heavily influenced by energy prices because fuel costs drive transportation prices, affecting the prices of all consumer goods. Again, the sharp rise in the US trade deficit over recent years exacerbates this dependence by causing more transportation pricing into goods. Thus, we should only expect inflation to fall if crude oil becomes cheaper. An economic recession, potentially triggered by Federal Reserve hikes, can push oil prices lower; however, international and domestic efforts to combat falling oil prices could entirely offset the impact of a slight decline in oil demand.
Total US production of oil remains below pre-COVID levels. Since the oil price is near the breakeven profit level for new wells, US producers are rapidly reducing drilling rates, lowering future output levels. Saudi Arabia is also reducing its output and is looking toward another OPEC cut this summer, likely due to the recessionary concerns regarding demand. Total US crude oil inventories are very low today due to the deficit in 2021-2022 and are falling again, signaling a significant potential increase in oil prices, mainly if supplies fall, as expected. Accordingly, I believe inflation has a substantial potential to remain around 4-5% and rise by year-end, even if economic demand continues to slow – mainly due to the crude oil dependence on prices.
Inflation-indexed bonds are currently bracing for a recession. Since these assets pay such a significant premium to inflation, they’re “pricing in” a normalization of inflation to 2% by mid-2024. Indeed, a recession appears quite likely, given the state of the manufacturing PMI and the extremely inverted yield curve. See below:
These robust leading economic indicators signal an impending contraction in activity. Usually, yield curve inversion signals a recession, but recessions typically coincide with a sharp “re-steepening” of the yield curve or a rise in long-term interest rates compared to short-term rates. The yield curve is around a record inversion level today and fell back down after rebounding earlier this year. That implies a recession could still be a quarter or two away but could be significant. If so, the Federal Reserve may look to lower interest rates even if inflation does not decline as much as it hopes, catalyzing a potentially sharp decline in short-term real interest rates.
Of course, VTIP is closely inversely correlated to shorter-term real interest rates. Data on real two-year rates are not published (most relevant for VTIP); however, the relationship remains clear for VTIP and five-year real rates (around 1% lower than short-term real rates). See below:
The five-year real interest rate is very high today at 1.8%, with the two-year even higher at around 2.75%. An economic slowdown will almost certainly cause real interest rates to reverse lower toward zero. VTIP’s duration is 2.5X, so a 1-3% decline in real interest rates would cause its value to rise by around 2.5 to 7.5%. That change would effectively cause VTIP to return to its pre-2022 price range of ~$50. In my view, VTIP is relatively likely to appreciate over the next twelve months; however, its abnormally high yield today and the potential sustained increase in inflation are my primary bullish arguments for the fund.
The Bottom Line
Overall, VTIP is one of my favorite assets in the current market environment. Its risk profile is extremely low since it owns short-term Treasury bonds with less duration risk and negligible credit risk. Unlike traditional Treasuries, VTIP would hypothetically retain its value if the US government printed money to repay its debt, creating high inflation. In that regard, VTIP is essentially lower risk than standard short-term Treasuries and is nearly the lowest-risk asset in the entire financial market.
On top of that, VTIP’s dividend yield is likely to be around 5-7% over the next year, or at least 2.75%, plus the CPI inflation rate. VTIP’s real yield has never been as high as it is today and is primarily driven by a combination of a high base rate (the rate set by the Federal Reserve) and what I believe to be a significant underestimation of future inflation. My base case view is that inflation will remain near current levels (likely falling and rebounding with oil). At the same time, the Federal Reserve reduces interest rates due to a slowing economy. If that occurs, VTIP would deliver a solid 5-7% yield this year and appreciate 3-7% in value as real interest rates return to normal levels, potentially creating a double-digit total return on an extremely low-risk asset.
Of course, reality can deviate from my outlook should economic and financial conditions change. For one, crude oil may continue to slide should production cuts not pan out or if economic demand falls quickly. If so, inflation could continue declining and temporarily become negative, potentially harming VTIP’s value. It is also possible that real interest rates rise even higher if the Federal Reserve felt the need to raise interest rates even higher. Of course, both potentials would almost certainly not occur together because the Fed would likely only raise rates again if inflation rebounds (which would benefit VTIP). Further, while a recession could cause oil to decline further, labor shortages and import instability should be sufficient to spare the market from deflation.
To me, in the best-case scenario, VTIP will pay a double-digit total return over the next twelve months. In the worst-case scenario, its total return should still be positive due to its high real yield, higher inflation, and lack of impending Federal Reserve hikes. That said, inflation-indexed bonds can be sensitive to bond market liquidity, as seen in its sharp temporary decline during the 2020 market crash. I believe the Federal Reserve’s effort to ensure liquidity (as seen in the recent bank crisis) largely offset this risk; however, VTIP may suffer a material decline during a stock or bond market crash based on historical precedent.
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