SCHP: TIPS ETFs May Perform Best In Slowing Inflation Scenario

In 2022, investors who bought TIPS-focused ETFs like the Schwab U.S. TIPS ETF (NYSEARCA:SCHP) hoping for protection against soaring inflation must have been sorely disappointed, as SCHP delivered -12.0% in total returns for the year, despite CPI inflation peaking at 9.0% YoY in June (Figure 1).

As I have written in prior articles, although TIPS bonds offer protection from inflation in the form of CPI-adjustments to its principal and coupons, at the end of the day, they are fixed income securities with duration risk. When interest rates rallied in 2022, TIPS-focused ETFs like the SCHP suffered duration declines in NAV that outweighed their gains from higher coupons.

One possible mitigating strategy I suggested was to hold the SCHP ETF, hedged with shorts on intermediate treasury funds like the iShares 7-10 Year Treasury Bond ETF (IEF), to take advantage of the enhanced yield on TIPS securities while minimizing duration risk. However, in my November update, I warned investors that:

However, if headline inflation, and more importantly, expectations on the terminal Fed Funds rate, have indeed peaked, then investors may want to consider removing this hedge.

I recommended investors monitor the ratio between SCHP and the IEF ETF, to determine whether the hedge should be lifted. Updating the ratio I previously posted, the SCHP / IEF ratio has indeed completed a significant topping pattern (Figure 2).

This implies that IEF is now outperforming the SCHP on a total return basis and SCHP investors should no longer hedge duration.

Inflation Has Peaked, Now What?

The recent December CPI report confirmed my suspicion that inflation was peaking for this cycle, with headline CPI inflation falling 0.1% MoM in December, despite the YoY figure staying elevated at 6.5% (Figure 3).

TIPS bonds have their principal and coupons adjusted for the prevailing level of the CPI Index. When the CPI index falls like it did in December, then the CPI-adjustment will be detrimental to TIPS bonds’ principal and coupons.

Duration Acting In Reverse

Counteracting this principal/coupon decline is that fact that market participants have concurrently brought down their expectations of long-term treasury yields. Traders are increasingly convinced the Fed will be reducing interest rates in the second half of 2023, either as a result of achieving a soft landing scenario or to stimulate growth in the face of a recession. The market now expects Fed Funds rate to peak in June 2023 at 4.85% and decline to 4.4% by year-end (Figure 4).

The positive impact from lowered interest rate expectations have outweighed slowing gains (and decrease in December) in CPI-adjustments, allowing the SCHP to deliver positive returns in Q4/2022 and in the first few weeks of 2023.

Paradoxically, SCHP May Perform Best In Slowing Inflation Scenario

Paradoxically, the SCHP ETF may perform best in a slowing inflation scenario, where the CPI Index still climbs, but at a modest pace, provided interest rates are declining to provide a duration tailwind.

However, there are 2 things investors should monitor:

1) Headline inflation. Investors should closely monitor the upcoming CPI releases to see if the December -0.1% MoM reading was just a statistical anomaly, or if the economy is falling into a bout of ‘deflation‘ that is commonly associated with recessions. As explained above, TIPS bonds’ CPI-adjustments act in reverse when the CPI index is declining.

2) Market interest rate expectations. Currently, market participants are expecting the Fed to start cutting interest rates in the second half of 2023. This is in stark contrast to what the Fed is actually saying: that they will raise rates to a higher than expected level and stay there for an extended period of time. If the market is wrong and the Fed actually keeps interest rates ‘higher for longer’, there may be a sharp adjustment to long-term treasury yields as market expectations are brought back in line with the Fed’s policies. Higher interest rates will be detrimental to TIPS funds due to duration, similar to 2022.

Conclusion

The SCHP/IEF ratio has made an important top, implying that SCHP holders should no longer hedge their duration exposure. Paradoxically, the SCHP ETF may perform best with headline inflation slowing and market expectations for interest rates declining.

However, investors should keep an eye out for signs of ‘deflation’ that will negatively impact SCHP’s CPI-adjustments. Investors should also monitor market interest rate expectations, as there is a wide gap between the Fed’s stated policies and expectations for the Fed to cut interest rates in H2/2023.