SCHP: Real Yields Dropping – Playing The TIPS Market Through SCHP

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

0.75% of Rate Cuts Discounted in 2023

The CME FedWatch probabilities chart shows interest rate increases at each of the following three Fed meetings before a pause and possible loosening cycle next year.

Traders See Fed Funds Peaking Near 3.5% in 2022

Treasurys have caught a major bid over the last six weeks. Since the last time the FOMC gathered, the U.S. 10-Year Note’s yield has dropped from about 3.50% to near 2.75% last week, according to The Wall Street Journal.

Treasury Note Yields Drop Markedly Off the June Peak

Right now, the yield curve is the most inverted it has been since 2000, a clear sign that bond traders see recession risks rising. The good news for savers is that while inflation is still cooking at 9.1% (year-over-year through June), short-term Treasury securities yield about 3.0% – the highest since 2001.

Savers Rejoice: 1-Yr Treasury Rate Now Above 3%

All these monster moves in Treasury Bills and Notes come as inflation fears ease. The five-year breakeven inflation rate, according to trading markets, notched a fresh 10-month low last week at 2.56%, down one percentage point from the high earlier this year. The “5y5y” forwards also retreated off the year-to-date zenith near 2.6%. A popular investment, along with Series I Savings Bonds, had been owning inflation-protected U.S. Treasury securities through various ETFs. One ETF is among the most liquid and lowest cost you’ll find: the Schwab U.S. TIPS ETF (NYSEARCA:SCHP), much less expensive 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 U.S. Treasury securities. With an average maturity of 8.0 years, it’s a broad gauge of the TIPS market. The ETF wrapper also provides some tax efficiency versus a mutual fund. SCHP features a median bid/ask spread of just 0.02% and an expense ratio of only 0.04%. The weighted average yield to maturity is 2.42% as of March 31, 2022.

The Technical Take

The TIPS ETF sharply beat the iShares 7-10 Year Treasury Bond ETF (IEF) handily from the fourth quarter of 2021 through mid-April this year. Since about Tax Day, however, inflation fears have eased. Ergo, IEF has beaten SCHP. But is now the time to buy the dip (on a relative basis) in SCHP?

TIPS vs Treasurys: Eyeing the Early 2020 Consolidation

I say, “not quite yet.” I think SCHP could fall back to where it stood relative to IEF in mid-late February (about when Russia invaded Ukraine and when commodities began to spike). Until then, relative strength is on the side of plain old Treasurys (IEF). Wednesday’s FOMC interest rate decision could change the narrative – I would be a buyer of SCHP over IEF if we see a further retreat, targeting the 0% real yield rate.

10yr TIPS Yield: A Move Back to 0%?

The Bottom Line

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