Using Inflation Swaps for a more targeted inflation hedge

With U.S. rate cuts seemingly on-hold and a recent survey of U.S. Inflation expectations reaching heights not seen since the 1980’s we look at the track-record of two common inflation hedging strategies.

Earlier in May, the FOMC held rates steady, but updated its policy statement highlighting the rising risk of a environment¹. Stagflation = Stagnation + Inflation, a term coined in 1960’s United Kingdom for a combination of high inflation, stagnant economic-growth and elevated unemployment.

Although the April US CPI ticked up slightly, rising 0.2% month-over-month (MoM), it was slightly below the 0.3% increase expected, perhaps giving the Federal Reserve more time to wait and see regarding the potential impact of tariffs on consumer prices.

Be that as it may, a recent survey from University of Michigan² carried out between 25^th March and 8^th April, found that “Year-ahead inflation expectations surged from 5.0% in to 6.7%, the highest reading since 1981 and marking four consecutive months of unusually large increases of 0.5 percentage points or more.“

Consumer outlook may be somewhat softened by the subsequent partial reversal of tariffs, but there’s no doubt that trade policy continues to weigh heavily on consumers’ minds.

May has also seen Moody’s downgrade the United States of America’s long-term issuer and senior unsecured ratings to Aa1 from Aaa³. In their rationale for the downgrade, Moody’s cited sharply rising US Federal debt, rising interest rates and markedly increased interest payments, all due to continuous and widening fiscal deficits.

News that Trump’s “One Big Beautiful Bill’ is has been approved by the House of Representatives plays further into this narrative. The nonpartisan Congressional Budget Office estimate⁴ that this massive tax and spending bill will add $3.8tr to the US’s outstanding in debt over the next decade.

With this backdrop of higher inflation expectations and worries about U.S. debt and deficits weighing on the bond markets, we look back on the 5 year track-record of two common inflation hedging strategies, TIPS and Inflation Swaps.

For many investors, an allocation to TIPs (or Treasury Inflation Protection) securities has been the inflation hedge du jour. However it’s worth reminding ourselves that although TIPs prices are sensitive to inflation expectations, they are primarily driven by interest rates, and in particular by inflation-adjusted interest rates – so called real rates.  Put simply, as real rates rise, real prices fall and vice versa.

An alternative strategy is to hedge against changes in expected inflation using inflation swaps. These instruments are sensitive to expected inflation without the swings and volatility caused by changes in real rates.

As we can see in the graph above, real rates have trended up over the last five years.  As expected, this has had a marked effect on TIPs prices. To examine this further we look at the relative performance of a market weighted TIPs portfolio (we’ll use the TIP US ETF) compared with a fully funded monthly rolling inflation swap strategy of similar duration.

We can clearly see from the graph above that, over this horizon, the TIPs portfolio has underperformed the inflation swap strategy due to rising real yields.  Over the same period, the inflation swap strategy has provided more consistent returns with lower risk.

What lessons can investors draw from this:

• In a rising real rate environment, TIPs have clearly underperformed. But for an investor who is worried about future inflation but is also bullish about rate cuts they may still fit the bill.
• Meanwhile, investors who are more sanguine about rate cuts, but still worried about inflation may want to look at using inflation-swap strategies such as the one above. These types of strategy can provide investors a degree of protection against changes in inflation expectations without taking on rates risk, thus allowing for a more targeted investment approach.

Parameta Solutions offers a range of indices tracking the performance of systematic inflation swap strategies, covering prominent markets. To learn more about Parameta Solutions indices and their uses, please contact [email protected].