US Inflation Weakens: Avoid TIPS

Data released on July 14, 2017 indicates that US Consumer Price Index growth declined in June. Consumer prices grew 1.6% year over year in June 2017 compared with 1.9% growth in May, far from Fed’s 2% target. The number had reached a five-year high of 2.7% in February 2017. Fed’s preferred inflation measure, the core Personal Consumption Expenditures (PCE) index, stands at 1.4% as of May 2017.

In the congressional testimony last week, Janet Yellen dismissed inflation figures as temporary. However, she also cited that the Fed will be focusing on inflation numbers and that persistent weak inflation figures will lead it to hike rates slowly. Four consecutive declines have weighed on the possibility of further rate cuts. Per FOMC Fed fund futures data, odds of a 25 basis points rate hike in December have declined to around 47% (read: Dovish Yellen Testimony to Boost These ETFs).

This led to a rally in treasury prices, as yields declined. The 10-year US Treasury yield reached a month low as the economic data was released.

Moreover, in June 2017, the producer price index (PPI), a measure of wholesale price inflation, grew 2% year over year compared with 2.4% in May. It increased 0.1% in June on a monthly basis. US Consumer confidence, represented by University of Michigan's consumer sentiment index declined to 93.1 in July 2017 compared with 95.1 in June (read: U.S. Producer Prices Up: ETFs in Focus).

Although the labor market is healthy, as 247,000 people applied for jobless benefits in the week ended July 8, 2017 compared with 250,000 in the previous week, wage growth is sluggish. Therefore, consumers are cautious about increasing spending (read: ETFs to Win or Lose Post June Jobs Data).

Let us now discuss a few inflation-protected ETFs (see all Inflation-Protected Bond ETFs here).

iShares TIPS Bond ETF (BK:TIP)

This fund focuses on providing exposure to TIPS, U.S. government bonds that adjusts its principal based on inflation numbers. It thus protects investors from unexpected increases in inflation.

It has AUM of $23.16 billion and charges a fee of 20 basis points a year. The fund has a weighted average maturity of 8.41 years while it has an effective duration of 7.68 years. It has a dividend yield of 1.87%. TIP lost 0.11% year to date and 2.82% in the last one year (as of July 14, 2017).

Vanguard Short-Term Inflation-Protected Securities ETF (BK:TIP)

This ETF focuses on providing exposure to short-term TIPS, whose face value is indexed to inflation.

It has AUM of $20.1 billion and is a relatively cheaper bet as it charges a fee of 7 basis points a year. The fund has a weighted average maturity of 2.7 years and an effective duration of 2.7 years as well. It has a dividend yield of 0.76%. VTIP lost 0.52% year to date and 1.24% in the last one year (as of July 14, 2017).

Schwab U.S. TIPS ETF (SIX:SCHP)

This fund seeks to invest in TIPS and track the performance of Bloomberg Barclays (LON:BARC) U.S. Treasury Inflation Protected Securities (TIPS) Index.

It has AUM of $2.08 billion and is a cheaper bet as it charges a fee of 5 basis points a year. The fund has a weighted average maturity of 8.3 years and an effective duration of 7.6 years. It has a dividend yield of 1.97%. SCHP returned 0.24% year to date but lost 2.83% in the last one year (as of July 14, 2017).

FlexShares iBoxx 3-Year Target Duration TIPS Index Fund TDTT

This fund seeks to invest in inflation protected securities and track the performance of the iBoxx 3-Year Target Duration TIPS Index.

It has AUM of $2.04 billion and charges a fee of 20 basis points a year. The fund has a weighted average maturity of 3.07 years and a modified adjusted duration of 3.05 years. It has a dividend yield of 1.97%. TDTT lost 0.81% year to date and 1.57% in the last one year (as of July 14, 2017).

Bottom Line

Despite the Federal Reserve’s belief of the weak inflation numbers being ‘transitory’, persistent weakness has sparked concerns in the markets. Therefore, this has clouded the outlook for further rate hikes and the inflation figure reaching Fed’s 2% target. As a result, given the current market environment, we believe it is best to avoid inflation-protected securities for now.

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