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Tom Graff🇺🇦

Tom Graff🇺🇦

Nov 23
16 tweets

OK, so let's play this through... (spoiler alert, I think this trade is dumb) 1/

Bill Gross

Bill Gross

10 year TIP breakeven yield at 230. Should be closer to 300. Switch any treasuries you own into TIPS.
For the 10yr TIPS to trade with a breakeven of 3.00, markets have to assume that the *average* inflation rate will be 3% over the next 10 years. Is that possible? I suppose in an infinite universe all things are *possible* but boy... seems quite *implausible*. 2/
There are two major reasons why TIPS would trade with ~3% breakeven. The first is that the Fed has basically given up on its inflation target of 2%. While the Fed's target is actually based on Core PCE inflation, the gap to Core CPI isn't going to be 100bps. 3/
There is *zero* chance the Fed gives up on 2% target. The absolute most I can believe is that they become more tolerant of inflation volatility. But they still want 2% to be the target. If Gross likes TIPS bc he thinks the Fed will throw in the towel, that's a very bad bet. 4/
A much more reasonable bet would be that the market decides that persistently rising energy prices will cause CPI to run much higher than Core PCE. Maybe, but let's remember that was rare. This chart shows overall CPI - Core PCE. Gaps of 100bps exist, but they don't persist. 5/
So is the implication that TIPS are just a way of playing energy prices? 6/
Now look, if you want to play oil prices rising precipitously into a global economic slowdown, be my guest. Wouldn't be a bet I'd make, but you do you. 7/
But wait, it gets worse for TIPS... 8/
I work for clients that invest for long-term goals, so let's play through how TIPS work out as an allocation in a broader portfolio. 9/
Let's say Gross is right and 10yr TIPS breakevens jump to 3%. Let's say you have excellent foresight and sell your standard bonds for a 10yr TIP. That would be worth about 7% in price return. Sounds pretty good right? Well... 10/
If inflation has jumped to 3%, presumably the Fed has kept hiking well beyond what is currently assumed. That would very likely mean the 10-year Treasury is substantially higher than it is now. Hard to know how much, but I could believe 5-6%. 11/
If you traded a standard bond allocation like $BND for a 10-year TIPS you've increased your duration from about 6.5 to 9.3. While you didn't suffer for the 0.7% increase in inflation, you suffer about 50% more as real rates rise. You could easily be net worse off. 12/
Ah but why not just buy a shorter TIPS? Well then you will get less benefit from getting your inflation call right. Buying a 5-year TIPS would get you half of the upside. Pretty soon it becomes a waste of energy. 13/
Now pretty much the only way that inflation goes higher and real rates don't rise that much would be if energy prices keep rising. That probably requires that the economy does better than is currently feared. But if that happens, are TIPS your best move? 14/
Why not just buy boring old investment-grade corp bonds? - The IG index yields 5.4%, so if nothing happens you earn more yield than TIPS. - If economy does well, you get spread compression - If inflation subsides, the Fed stops hiking, you prob also get spread compression 15/
IMO, TIPS are just a trading vehicle. It is a low vol way of playing food and energy prices. They are a poor hedge of inflation and generally a drag on the income generation of bond portfolios. Bill Gross can have 'em. I don't want them. (fin)…
Tom Graff🇺🇦

Tom Graff🇺🇦

Head of Investments @facetwealth. Followers should expect fairly boring and nuanced takes. Hopefully informative, but no promises.
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