Inflation has been a hot topic in recent months. There is growing evidence that inflation may be subsiding due to the aggressive interest rate hikes by the US Federal Reserve. That evidence can be seen clearly in the bond market. Arguably the most trustworthy people to take advice from are bond traders. So, it's no surprise I'm looking at what they're thinking. Take a look at, for example, the TIP/IEF ratio which we'll talk about in this post.
The TIP/IEF ratio is a measure of the relative value of two types of bonds: Treasury Inflation-Protected Securities (TIPS) and 7-10 Year Treasury Bonds (IEF). TIPS are a type of U.S. government bond that is designed to protect investors from inflation. They are issued by the U.S. Department of the Treasury and pay a fixed rate of interest to investors. The principal value of TIPS is adjusted for inflation, which means that the value of the bond increases over time as the cost of living rises. IEF, on the otherhand, is an exchange-traded fund (ETF) that tracks the performance of U.S. Treasury bonds with maturities between 7 and 10 years. These bonds are also issued by the U.S. government and pay a fixed rate of interest to investors, but unlike TIPS, they do not offer protection against inflation, which is the key factor here.
Take a look at the chart below. The ratio is currently hanging on by a thread awaiting a breakdown. Should that breakdown materialize we could also expect inflation to subside, which means that commodities could slide further down. Some stocks such as the ones in the energy sector might start sliding too.
The decline in the value of TIPS relative to IEF can be attributed to a number of factors. One of the few reasons is the recent decline in inflation expectations. Inflation expectations refer to the market's expectations for the level of inflation in the future. When inflation expectations are low, the relative value of TIPS tends to decline, as investors are less willing to pay a premium for the inflation protection they offer. This is of course due to the increase in interest rates. The U.S. Federal Reserve has been aggressively raising interest rates in recent months in an effort to curb rising inflation. Here's a chart to give you an idea of the extent of the rate hikes by the FED. Hat tip to Chartr.
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Here's a chart of the ratio together with the US inflation rate to give you a clearer view. At times, the drop in the TIP/IEF ratio leads the drop in inflation. There is a correlation between the US inflation rate and TIP, as changes in the inflation rate can affect the value of TIPS and, in turn, the performance. In general, when the inflation rate is expected to rise, the value of TIPS tends to rise as well, as the adjusted principal increases in value along with the inflation rate. Conversely, when the inflation rate is expected to be low, the value of TIPS tends to be relatively stable, as the adjusted principal does not increase as much.
