SCHP: Falling Real Yields – Playing the TIPS Market via SCHP

Ahead of a pivotal Fed meeting on Wednesday, bond traders appear to believe interest rate cuts are on the horizon soon after this year’s tightening cycle. Currently, market prices in nearly three rate cuts in 2023 after the the policy rate could peak between 3.25% and 3.50% later this year.

0.75% of discounted rate cuts in 2023

The CME FedWatch probability chart shows interest rate hikes at each of the next three Fed meetings before a pause and possible easing cycle next year.

Traders see Fed Funds peaking at nearly 3.5% in 2022

Treasuries have caught a major bid over the past six weeks. Since the last FOMC meeting, the yield on the US 10-year note has risen from around 3.50% to almost 2.75% last week, according to The Wall Street Journal.

Treasury yields fall sharply from June peak

Right now, the yield curve is the most inverted since 2000, a clear sign that bond traders see rising recession risks. The good news for savers is that while inflation continues to cook at 9.1% (year-on-year to June), short-term Treasuries are yielding around 3.0% – the highest since 2001.

Savers rejoice: the 1-year Treasury rate is now above 3%

All of these monster moves in Treasuries and Notes come as inflation fears wane. The five-year breakeven inflation rate, according to stock markets, hit a new 10-month low last week at 2.56%, down one percentage point from the peak reached earlier this year . “5y5y” forwards have also fallen from the zenith year-to-date at nearly 2.6%. A popular investment, along with Series I savings bonds, had been to hold inflation-protected US Treasury securities through various ETFs. An ETF is among the most liquid and cheapest you will find: the Schwab US TIPS ETF (NYSEARCA:SCHP), much cheaper than the popular iShares TIPS Bond ETF (TIP).

According to Schwab, SCHP’s goal is to track as closely as possible, before fees and expenses, the total return of an index composed of inflation-protected US Treasury securities. With an average maturity of 8.0 years, it is a broad indicator of the TIPS market. The ETF wrapper also offers some tax efficiency compared to a mutual fund. SCHP has a median bid/ask spread of just 0.02% and an expense ratio of just 0.04%. The weighted average yield to maturity is 2.42% as at March 31, 2022.

The technical grip

The TIPS ETF significantly beat the iShares 7-10 Year Treasury Bond ETF (IEF) easily from the fourth quarter of 2021 to mid-April this year. Since tax day, however, inflation fears have subsided. Ergo, IEF beat SCHP. But is now the time to buy the dip (on a relative basis) in the SCHP?

TIPS vs. Treasurys: Looking to early 2020 consolidation

I say “not quite yet”. I think SCHP could fall back to where it was relative to IEF in mid to late February (roughly when Russia invaded Ukraine and commodities started to soar). Until then, relative strength is on the side of the good old treasures (IEF). Wednesday’s FOMC interest rate decision could change the narrative – I’d be a buyer of SCHP rather than IEF if we see another pullback, targeting the 0% real rate of return.

10-year TIPS yield: a return to 0%?

The essential

All eyes are on President Powell. This week’s Fed meeting should bring more volatility to the Treasury market. Real yields have fallen to around 0.43%, according to Treasury.gov, after approaching 0.80% earlier in 2022. The chart suggests the rate could drop further to near equilibrium, at which time owning SCHP rather than IEF would make sense.