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Understanding TIPS: The Compelling Case For Rising Interest Rates And How To Benefit From Them

By Kurt Osterberg · On August 10, 2018

As we head further into 2018, the case for rising interest rates is compelling, and it Really is All About Supply and Demand!

On the demand side, those buyers of treasuries that are traditionally the largest are reducing their participation in the market, thereby reducing demand and leading to lower prices and higher yields. Specifically:

The US Fed: After years amassing a total portfolio of $4 trillion of treasuries (mostly through ’Quantitative Easing’), the Fed announced at the end of 2017 that they will be letting these treasuries unwind. This means they will not be reinvesting in new treasuries as the ones they are holding mature.

The Chinese Government: With holdings in excess of $1.2 trillion, China has been the second largest holder and buyer of US treasuries. However, on Jan 12, 2017, Chinese officials announced that they were curtailing purchases of US treasuries.

Japan: The 3rd largest holder of treasuries, has steadily reduced their holdings and new purchases of Treasuries as well, with the latest drop of 0.9% to $1.08 trillion being the lowest in more than 4 years (Bloomberg: Jan 2018).

The Data: Back in 2004 – 2005, China and Japan combined accounted for more than 50% of foreign holdings and purchases of US Treasuries. As of November 2017, that amount had dropped to just 36%.

The FOMC: They have specifically told us that they expect to raise the Federal Funds rate at lease 3 times this year (depending on economic activity).

On the supply side, the argument is just as compelling. Today, the US Deficit is at its highest level ever, requiring unprecedented treasury issuances. It is estimated that the deficit will grow by an additional $1.4 trillion in 2018, requiring new treasuries to be issued in that amount. However, it is worth noting that fiscal optimists hope that the recent Tax Bill passed in 2018 will result in stronger economic growth, thereby reducing the deficit and the amount of treasuries that need to be issued. Time will tell.