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Vanguard VTIP ETF: A Better Alternative to Cash (NASDAQ: VTIP)

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I have generally been bullish on Inflation-Protected Treasury Securities (TIPS) bonds since the massive sale that we saw during the Covid crash of March 2020 (see ‘Inflation-linked bonds offer an excellent risk-return compromise ”). While long- and short-dated TIPS performed well over this period thanks to the sharp rise in the consumer price index, the long end of the curve outperformed thanks to strong capital gains. I continue to see the long term outperforming the long term as the Fed pushes real bond yields deeper into negative territory. However, for investors looking for less volatility, the short end of the TIPS curve may also be attractive as an alternative to cash.

The Vanguard Short-Term Inflation-Protected Securities ETF (NASDAQ: VTIP) tracks an index of inflation-protected US Treasury securities with a maturity of less than 5 years and an average effective maturity of 2.5 years. For VTIP to outperform cash in the next few years, a thing or two must happen. Either, real returns must fall deeper into negative territory, resulting in capital gains. Or, the reported CPI must exceed the current actual return by -2.7%.

Positive real returns are over, but outperformance against cash is likely

Since the Covid crash, these two forces have worked in favor of VTIP. Even though nominal yields have risen, inflation and inflation expectations have risen faster. This allowed VTIP to register capital gains and benefit from the impact of higher coupon payments resulting from the rise in real inflation. These capital gains enabled the VTIPs to post positive real returns despite their negative returns.

Total return VTIP to CPI, rebased

Total return of the VTIP ETF relative to the CPI

The VTIP outperformed inflation

Bloomberg

With the current yield of VTIP near its all-time low of -2.7%, positive real returns are highly unlikely. However, an outperformance against cash is still very likely in my opinion. Assuming that real yields themselves remain unchanged, that would require an average inflation of 2.7% over the next 2.5 years.

Predicting inflation is notoriously difficult at the best of times, but there are currently so many extreme inflationary and deflationary forces at play that it makes matters even trickier. For example, on the one hand, we have pursued rapid money supply growth and huge budget deficits, while on the other hand, we have, in my opinion at least, the largest asset bubble that the American economy has ever known. Overall, I think the risks are weighted on the upside. Money supply growth continues to far exceed the growth rate of GDP, necessitated by the government’s huge budget deficit, meaning that even the current high inflation rate of 6.8% is being suppressed by the decrease in the speed of money. While that doesn’t mean that I think inflation will continue to rise, it does show how extremely accommodative monetary and fiscal policy has created the conditions for a potential inflation problem if public confidence in the reserve in value for money was decreasing.

Another reason to favor VTIP

Another reason I would recommend VTIP over regular bonds or cash to anyone looking to profit from a decline in stock prices is because it acts as a hedge against continued increases in stock valuations. Based on recent correlations, if stock valuations were to continue to rise, it would likely be because real yields have fallen, which should also allow VTIP to outperform bonds or cash. While this also means that in the event of a stock market crash VTIP would likely underperform, the holder would likely still outperform stocks significantly.

Total return VTIP compared to S & P500

Total return of the VTIP ETF vs the S&P 500

VTIP positively correlated with stocks

Bloomberg

Summary

The VTIP has not only kept pace with inflation over the past two years as expected, it has in fact appreciated in real terms thanks to strong capital gains against a backdrop of declines. sharply rising inflation expectations. With real yields now deeply negative, VTIP should underperform inflation over the next few years, but it is highly likely to outperform cash.