TIPS Underperform Treasurys in the 2018 Third Quarter

As interest rates marched higher, TIPS underperformed comparable maturity straight Treasurys for the first time in five quarters. On average, TIPS lost 1.1% in the third quarter, worse than the 0.7% loss on comparable maturity straight Treasurys. The average yield on TIPS rose by 33 basis points (bp) to 0.92%, compared with the 23 bp increase to 2.97% for Treasurys. As a result, the average spread between straight Treasurys and TIPS yields declined by 10 bp from 215 bp to 205 bp.

The faster rise in TIPS yields and decline in the average spread suggests that inflation expectations moderated slightly during the quarter. Investors sought a higher yield on TIPS to compensate for a lower anticipated inflation adjustment.

As was the case in previous quarters, the returns on longer maturity securities were more volatile. Long-maturity TIPS suffered a 2.6% decline, worse than straight Treasurys 2.2% decline. In contrast, short-maturity TIPS and Treasurys posted slightly positive returns. This range of performance is expected in a rising rate environment.

The gain in TIPS from the inflation adjustment eased from the 2018 third quarter. During the 2018 third quarter, the CPI rose by 0.6% year-over-year, less than the 2018 second quarter’s 1.1% gain. The CPI had been rising progressively faster pace for most of 2018, but August saw a lower increase in both the headline and core CPI. Headline CPI eased from 2.95% in July to 2.70% in August and core CPI (excluding food and energy) eased from 2.35% to 2.20%. With the 17% increase in the price of oil since mid-August and the 12% increase in the price of natural gas since early September, it is a fair bet that headline CPI will rise at a modestly faster pace in the months ahead.