Higher inflation expectations diminish TIPS outlook

Key Takeaways

• Treasury inflation-protected securities (TIPS) can offer investors some peace of mind with respect to upside inflation shocks, but the recent spike in near-term inflation expectations will make it difficult for TIPS to outperform nominal U.S. Treasuries over the near term.
• As more attention has shifted away from tariffs’ potential impact on inflation towards their effects on growth, nominal U.S. Treasuries have outperformed TIPS. We expect this to continue.

Key characteristics & how they are used

Over time, rising inflation can erode the real value of a bond’s fixed income stream (i.e., inflation risk). Post-pandemic, Treasury inflation-protected securities (TIPS) received heightened attention as bond investors sought ways to protect their portfolios against generationally high inflation. Heightened global trade tensions – namely, the uncertain impact of tariffs on inflation – have reinvigorated the conversation around the value of TIPS.

The principal value of TIPS is tied to the headline U.S. Consumer Price Index (CPI). As inflation increases, the principal value adjusts higher, increasing the total interest paid. Thus, the interest paid effectively floats with the direction and magnitude of CPI. However, TIPS are somewhat less liquid than nominal U.S. Treasuries and typically underperform nominal U.S. Treasuries when market sentiment shifts from risk-on to risk-off. 

Relative value & risk/reward to nominals

For investors, the decision to incorporate TIPS into portfolios involves weighing hard and soft factors: 1) their relative valuation compared to nominal U.S. Treasuries, and 2) the “peace of mind” TIPS can offer around inflation.

From a relative value standpoint, we currently see greater value in nominal U.S. Treasuries versus TIPS. The uncertain scope and impact of U.S. tariff policy has pushed inflation expectations sharply higher, particularly for the next few years. Thus, the bar has been raised significantly for actual inflation to exceed current expectations, which is a prerequisite for TIPS to outperform nominal U.S. Treasuries. Conversely, we see some major disinflationary forces still working through the data – particularly in shelter costs – that should keep inflation trending lower towards the Federal Reserve’s 2% target. Additionally, the recent soft patch in economic activity should dampen some of the inflationary impulses injected by tariffs. Over the past two months, weaker incoming data is also fueling a traditional flight-to-quality into nominal U.S. Treasuries, leading to TIPS underperformance. In sum, our total return outlook for nominal U.S. Treasuries remains more favorable relative to TIPS over the near term.

Still, there is a “peace of mind” component to TIPS. For some investors, the risk of higher-than-anticipated inflation eroding the purchasing power of any income generated is worth addressing. TIPS are an effective way to hedge against upside inflation shocks or if tariff negotiations devolve into a prolonged, escalating trade war that upends global supply chains. We expect the worst-case scenarios for inflation and trade policy will be avoided but the range of potential outcomes is atypically wide.

Bottom line

For investors looking for a sense of comfort in the face of trade-related uncertainty and its potential impact on inflation, TIPS can offer an effective hedge against upside inflation surprises. However, from a total return perspective, we still favor nominal U.S. Treasuries following the sharp uptick in consensus inflation expectations that will make it that much more difficult for TIPS to outperform. Additionally, we expect inflation to continue a gradual, bumpy cooling process, which runs counter to the TIPS market expectations for a rapid reacceleration in inflation.