Economics Inflation Rising Rates Fixed Income Blog

Why Is Inflation Protection So Cheap?

20 October 2023
4 min read

Real yields on US TIPS now exceed the rate of predicted future GDP growth. That’s good news for investors looking for affordable inflation protection. 

Thanks to the recent bond market sell-off, real yields on Treasury Inflation-Protected Securities (TIPS)—yields before the accretion of inflation—are now at their highest levels in the US since the global financial crisis (GFC). In our view, not only does that make locking in today’s higher yields a very good idea for bond investors, but it also makes buying inflation protection exceptionally cheap. Here’s why.

Real Rates Reach “Equilibrium”

A government’s ability to service its debts isn’t sustainable in the long run if the cost of borrowing exceeds the growth rate of its revenues. In turn, revenues generally rise in line with GDP growth. Thus, the cost of borrowing (rates) and economic growth (nominal GDP) must eventually be brought into balance. When the economy has reached its potential real growth rate—that is, potential nominal growth less inflation—real rates are at equilibrium. 

Inflation, as we’ve been reminded lately, is hard to predict. But the potential for real growth is not. It’s essentially the growth of productivity plus the growth of the labor force. And while productivity has been fairly stable over the past four decades, real GDP growth has declined due to the slowing growth of the labor force (Display 1). 

Declining Labor Force Growth Has Weighed Down GDP
Percent
Table shows correlation between generally lower labor force growth and GDP since 1983.

Current and historical analyses do not guarantee future results.
Data are the annual averages for the periods unless otherwise indicated.
As of June 30, 2023
Source: Bloomberg and AllianceBernstein (AB)

Indeed, because US unemployment is at its lowest rate since the 1960s, we must rely more than ever on the growth of the working-age population to drive growth in the labor force. But given dismal demographic trends, the US Bureau of Labor Statistics projects employment growth of just 0.3% annually between 2022 and 2032 and expects real GDP to grow at 1.9% annually, on average, over the same period. 

Today’s real yield levels are at or above this projected real GDP growth rate and appear to have reached equilibrium, suggesting that inflation protection may currently be cheap. We believe the best way for investors to access today’s affordable real rates is through TIPS. 

Sizing Up the Opportunity in TIPS

TIPS, like other instruments issued by the Treasury, are backed by the full faith and credit of the US government. They are designed to fully compensate the investor for inflation and, if newly issued, also provide protection against deflation—that is, inflation compensation will not be negative. 

Today, investors can buy 10-year TIPS whose annual return may, in our analysis, exceed the growth of the US economy over the next decade. For context, we compared the yields on 10-year TIPS to real GDP growth since 1997, when TIPS first came to market (Display 2).

Inflation Protection Has Gotten Cheaper
10-Year TIPS Yield vs. Annualized Real GDP Growth (Percent)
Line graph shows TIPS yields and real GDP growth converging near 2%.

Current and historical analyses do not guarantee future results.
As of September 29, 2023
Source: Bloomberg and AB

We found that, on average, TIPS yielded 90 basis points (bps) below GDP growth over that 26-year period. But if you were to buy a 10-year TIPS bond now, it would yield 50 bps above likely future GDP growth. In other words, TIPS are abnormally cheap. 

How did TIPS get so expensive, and why are they now so cheap? Look no further than quantitative easing—and its current antonym, quantitative tightening. 

Before inflation became an issue, the Federal Reserve ballooned its balance sheet by gobbling up government securities in an effort to increase the money supply and stimulate the economy. Not surprisingly, TIPS valuations rose, as did inflation expectations. 

But quantitative easing was only part of the story. After all, TIPS comprise only a small percentage of the Treasury’s borrowing program. More realistically, we believe the Fed’s practice of announcing its purchases and sales in advance is what really moved the TIPS valuation needle. 

Fed Signals Have Driven TIPS Valuations

Coming out of the GFC and again during the pandemic, the Fed not only tried to stimulate the economy but also wanted to stave off expectations of deflation. Using break-even rates as a gauge—that is to say, the rate of realized inflation that would make an investor indifferent between a 10-year TIPS and a 10-year Treasury note—the Fed intentionally drove real rates into negative territory for a time, artificially inflating TIPS prices.

Now, with the Fed waging an all-out war on inflation, just the reverse is happening. As it unwinds its balance sheet, the Fed is again telegraphing its moves, allowing the market to price for a smaller balance sheet by the time the Fed concludes its wind-down. As a result, Treasury yields are now as high as they were in the five years preceding the GFC, and TIPS compound annual returns will likely outpace the expected growth rate of the US economy over the next decade, making for a timely buying opportunity.

Bottom line: by purchasing TIPS now, investors get an asset backed by the full faith and credit of the US government that protects against inflation surprises and deflation, with the potential to outperform the US economy as a whole.

Timing is everything, and rarely has this kind of inflation insurance been this affordable. 

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to change over time.

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