Stagflation: the revival of Treasury Inflation-Protected Securities (TIPS)

As inflation remains elevated and there is the risk of rising again in the last quarter of the year, we favor short-term inflation linkers. Below, you will find a list of TIPS with a maturity of up to two years.

(2) Short-term US Treasuries. Central banks across both sides of the Atlantic have undertaken the most aggressive interest rate hiking cycle in centuries. Today investors have the chance to lock in one of the highest yields in decades, with US two-year yields paying almost 5%. As economic activity slows, the Fed might be unable to continue hiking, putting a cap on rates. At the same time, if the economy enters into a recession, the front part of the yield curve has the potential to collapse quickly, providing upside to bondholders.

(3) Short-dated investment-grade corporate bonds. As stagflation will put weaker corporates under pressure, we prefer quality over junk. Moreover, we favor short-dated corporate bonds with 1 to 5 years of maturity over longer maturities. Indeed, despite offering a considerably higher yield than historically, longer-dated corporate bonds don’t reward investors for taking on higher duration risk. Additionally, while the front part of the yield curve is capped amid a stagflationary environment, long-term rates can rise further as jobs and growth deteriorate slowly.

Why might long-term rates continue to rise?

Although we expect a slowdown in growth, we do not expect a blown-out recession and severely high rates of unemployment. That will allow the Fed to hold rates higher for longer, creating a natural floor for rates. However, mixed data and elevated inflation will contribute to higher rates.

Although we don't believe that the economy is facing the same stagflation woes of the '70s, it is helpful to see how rates reacted then to understand how they might behave today. Stagflation is defined as the CPI rate plus unemployment rates minus the real growth rate. If we chart this line together with 10-year US Treasury yields, we will see that during periods of stagflation, yields rise rather than drop.

For stagflation risk to increase, it is unnecessary to see a pickup in inflation; higher unemployment and growth deceleration will lead to the same result. Economists and central banks are already estimating rising unemployment and lower growth by year-end; therefore, the blue line will certainly tick up with 10-year yields following.

Hence, ten-year Treasury yields will likely soar to test their November high at 4.31%. Yields will remain in an uptrend unless they break below 3.75%.