TIPS ETFs have suffered outflows since April as investors position for economic weakness and falling inflation.
Conversely, ETFs tracking short-dated US government bond indices continue to enjoy strong inflows, on the back of attractive risk-free yields following the historic Federal Reserve hiking cycle between March 2022 and August 2023.
The iShares $ TIPS UCITS ETF (ITPS), which tracks the Bloomberg U.S. Government Inflation-linked Bond index offering exposure across the TIPS curve, has seen net outflows of $899m since the beginning of April, as per TrackInsight data to the end of August.
Outflows were particularly heavy last month with $696m leaving the ETF.
The iShares $ Treasury Bond 0-1yr UCITS ETF (IB01), which seeks to replicate the returns of the ICE U.S. Treasury Short Bond index, experienced net inflows of $4.3bn over the equivalent April through August period.
IB01 holds only nominal government paper – debt instruments with fixed, rather than inflation-linked, coupons and principal.
Its duration is substantially lower than ITPS’s given it holds no bonds with maturities longer than one year.
The contrasting fortunes in flows are logical. The expected return on TIPS, known as the real yield, has two components – nominal yields and inflation expectations.
Inflation expectations, or breakevens, tend to fall sharply during recessions as demand collapses across the economy.
Bond prices show that traders are already anticipating some economic frailty, particularly as core inflation continues to soften. At 30 August, five and 10-year breakevens sat at 2.01% and 2.15% respectively, well down from their April peaks of 2.52% and 2.44%.
Nominal bonds have therefore outperformed TIPS over the period.
Flows data show that many ETF investors, however, are preferring the front end of the yield curve.
IB01, for instance, yields 4.9%, well above the 3.9% currently offered by 10-year Treasuries. It carries far lower duration risk, too.
Short-dated government bonds also make sense for investors wary that a downturn in the real economy could trigger a sell-off in equity and credit markets.
The divergent flow dynamic within US government bonds ETFs will be challenged when the Fed begins it rate-cutting cycle, however, particularly if that easing takes place in the context of a strong economy.
Futures are pricing a cut of at least 25 basis points at the 18 September meeting and around four cuts by year end and is expected to bring the yield on short-dated US government paper down mechanically.
If the Fed eases policy as forecasted and the economy avoids recession, breakevens may once again look attractive again prompting a rotation back into TIPS ETFs.
