The price rally of the Schwab U.S. TIPS ETF (NYSEARCA:SCHP) on November 10th, 2022, further highlights the impact of duration on TIPS-focused ETFs. While the CPI inflation print came in lower than expected (which in theory should be detrimental to TIPS bonds), the SCHP ETF actually rallied as interest rates fell across the curve.
Investors who own the SCHP ETF hedged by shorts on intermediate bond funds like the IEF should closely monitor inflation and interest rate expectations in the coming months. There are signs that both are peaking. If that is confirmed, the hedge should be lifted.
Inflation Lower Than Expected, But TIPS-focused ETFs Are Rallying?
On November 10, 2022, U.S. CPI inflation came in lower than expected at 7.7% YoY on the headline and 6.3% YoY on the core, vs. expectations of 8.0% and 6.5% respectively (Figure 1).
In theory, lower than expected inflation should be detrimental to TIPS bonds, as their principal and coupons adjust to the actual inflation rates. However, TIPS-focused ETFs like the SCHP are actually rallying, with the SCHP up 1.2% as I write this article (Figure 2).
Investors must be scratching their heads and wondering what’s going on?
Duration At Play
Just to reiterate the main point in my prior articles that TIPS-focused ETFs have been whipped around in 2022 by their duration exposure, what we are witnessing today is the same duration driver, but operating in the opposite direction.
After the softer than expected inflation print, market implied projections for terminal Fed Funds rate declined by over 20 bps in 2023, from 5.01% in May 2023 to 4.79% (Figure 2). The thinking is that the lower November inflation print gives the Federal Reserve leeway to slow down the pace of their rate hikes, and potentially pause rate hikes altogether if inflation continues to soften in the coming months.
This has caused a sharp rally in treasury bonds, including TIPS bonds that make up the SCHP portfolio.
As a reminder, the SCHP ETF has an effective duration of 6.8 years (Figure 3).
If interest rates decline by 20 bps or 0.2%, then we should expect the SCHP ETF to gain in value by ~1.36%.
Is It Almost Time To Lift The Hedge?
In a prior article discussing the TIP ETF, I had recommended investors hedge out the duration risk of TIPS-focused ETFs like the SCHP by shorting a intermediate term treasury bond fund like the iShares 7-10 Year Treasury Bond ETF (IEF), to take advantage of the enhanced yield of TIPS bonds while minimizing duration risk.
With the SCHP ETF yielding 7.3% on a trailing 12M basis vs. the IEF ETF yielding 1.8%, investors holding the SCHP/IEF hedge could earn 5.5% (less borrow fees) with duration risk (SCHP has 6.8 years effective duration vs. IEF with 7.7 years effective duration) mostly hedged out.
However, if headline inflation, and more importantly, expectations on the terminal Fed Funds rate, have indeed peaked, then investors may want to consider removing this hedge.
SCHP / IEF Ratio Signal A Potential Top
Looking at the ratio between the SCHP and the IEF ETF, we can see that a potential topping pattern is developing. A top would be confirmed if the ratio declines below 0.538 (Figure 4).
The price action on the SCHP ETF on November 10, 2022 further highlights the impact of duration on TIPS-focused ETFs. While inflation came in lower than expected (which in theory should be detrimental to TIPS bonds), the SCHP ETF actually rallied as interest rates fell across the curve.
Investors who own the SCHP ETF duration hedged by shorts on intermediate bond funds like the IEF should closely monitor inflation and interest rate expectations in the coming months. There are signs that both are peaking. If confirmed, the hedge should be lifted, as the SCHP ETF would underperform the IEF ETF in total returns in a declining inflation scenario.
Image and article originally from seekingalpha.com. Read the original article here.