Inflation fears are back ahead of Trump's second term. Why investors burned before aren't eager to hedge against it.

MW Inflation fears are back ahead of Trump's second term. Why investors burned before aren't eager to hedge against it.

By Joy Wiltermuth

A Treasury auction on Thursday could provide clues to the appetite for inflation-protected securities ahead of Trump's second term

Inflation fears have re-emerged on Wall Street as investors brace for a barrage of policy changes under a second Trump administration and Republican control of government.

Yet with metrics pointing to higher inflation expectations and the previous popularity of the Treasury's inflation-protected securities, "TIPS" remain largely unloved by investors.

"They didn't work last time," said Gennadiy Goldberg, head of U.S. rates strategy at TD Securities, explaining that TIPS were created to help investors manage the risks of changes in the cost of living. But when real rates rose from negative territory, and kept climbing as the Federal Reserve starting raising interest rates at its quickest pace in decades, it jolted bond yields higher. Bond prices fell dramatically as a result, leaving many investors in TIPS facing unexpected losses.

As the historic 2022 bond rout revealed, TIPS with low starting yields weren't immune from the wreckage of mega swings in interest rates, especially for hard-hit longer-duration bonds.

Many investors responded to the rout by selling their TIPS, said Rodney Sullivan, executive direction of the Mayo Center for Asset Management at the University of Virginia. But they don't seem to have come back, even though inflation doesn't yet look defeated.

"There is a very sour memory," Goldberg said, especially when it comes to individuals and TIPS.

From April: Inflation is 'thorn' in market's side - but these ETFs rose even as stocks, bonds fell

Add in the Republican "red sweep" in November's election, with "pro-growth" Trump policies in play come January. The bullishness helped stocks and bitcoin set fresh record highs, even though investors don't yet know how Trump's return to the White House will ultimately shake out in terms of taxes, tariffs and immigration policy.

"You are not really seeing people hedge against downside risks," Goldberg at TD said.

Stocks as a hedge?

Despite the bullish tone in markets, rising long-term bond yields suggest that investors foresee an economy that keeps growing under Trump, but also risks of a bigger U.S. debt load, higher inflation and elevated Treasury issuance.

The push and pull has Wall Street focused on Trump's cabinet picks, including the fight over his Treasury secretary post, as a potential read on his priorities over the next four years.

"Yes, inflation is a risk," said Angelo Kourkafas, senior investment strategist at Edward Jones. "But not to the extent as in the last three years."

The consumer-price index for October showed inflation edging up to a 2.6% yearly rate, its first increase in seven months. While the Fed has wrestled it down from a roughly 9% pandemic peak, the central bank still wants to see it move closer to its 2% annual target.

Fed Chair Jerome Powell in early November said it could take "some years" for wages to help offset the sting of higher prices for households. More recently he said a slower approach to rate cuts probably makes sense.

In a reassuring move for Wall Street, Powell also said he wouldn't step down if asked to by Trump. His term ends in mid-2026, which should keep a pulse on inflation in the coming months.

Check out: Risk of conflict between Trump and the Fed 'is very high,' top economist Blanchard says

Kourkafas at Edward Jones said he doesn't expect another wave of inflation to crash into markets like it did in 2022, but he does foresee a sticky level of prices in the 2% to 3% range next year, which should enable modest Fed rate cuts.

Furthermore, stocks have been working well recently as hedge, he said, because corporations have been able to pass on higher costs to consumers. "What is needed for inflation protection is having assets that can match the pace of inflation."

The S&P 500 index SPX was up 24.1% on the year so far through Wednesday, while the Dow Jones Industrial Average DJIA was 15.2% higher and the Nasdaq Composite Index COMP was up 26.4%, according to FactSet.

Even the small-cap Russell 200 index RUT has advanced 14.7% so far in 2024, while shares of the iShares TIP Bond ETF TIP were up 0.3%.

TIPS

TIPS were introduced in the U.S. in the 1990s to help investors navigate the risks of rising or falling inflation. They have been sold by the Treasury with terms of 5 years, 10 years and 30 years.

Market-implied gauges recently have reflected concerns about the potential for inflation to rebound. The fear has been that Trump's plans for mass deportations and tariffs on U.S. imports could reignite inflation.

See: Stock market 'finally paying more attention to tariffs' as a potential headwind

The below chart reflects the increase in the 10-year break-even rate in November from September, a period that saw betting markets favor Republicans taking control of the White House and Congress.

To be sure, TIPS tend to be thinly traded, especially when compared with regular Treasurys, meaning that "pretty garden-variety flows or repositioning can cause big changes in TIPS yields," said Will Compernolle, a macro strategist at FHN Financial.

New TIPS issuance also can skew readings of market-implied inflation because new series tend to have a different coupon from the old ones, which can give the impression of an abrupt change in expectations, when there may not have been one, Compernolle said.

"The big drop on Aug. 3 was because it was the first business day after the new 10-year TIPS auction was settled, not because people radically changed their estimates of inflation over the next 10 years," he said.

Still, data hiccups don't explain the sharp rise in benchmark 10-year Treasury yields BX:TMUBMUSD10Y lately, nor the recent rise in 30-year fixed-rate mortgages back to nearly 7%.

As a real-time test of appetite for TIPS since the election, the Treasury on Thursday plans to auction $17 billion of securities that mature in a little less than 10 years, as part of a reopening of a prior issuance.

"There's a large degree of uncertainty as to what this administration will actually bring," Goldberg at TD Securities said of Trump's second term. "Investor were looking for clarity post-election. We don't really have it."

-Joy Wiltermuth

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November 21, 2024 07:00 ET (12:00 GMT)

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