Central bank action is “too little, too late”, says Tabula

Mar 24th, 2022 | By | Category: Fixed Income

Central banks have waited too long to raise interest rates as inflation continues to accelerate, according to fixed income ETF specialist Tabula Investment Management.

Jason Smith, CIO of Tabula Investment Management

Jason Smith, CIO of Tabula Investment Management.

Last week, the Bank of England increased its base rate for the third month in a row, while the US Federal Reserve kicked off its tightening cycle with a 0.25% hike.

While the European Central Bank has indicated it is currently in “no hurry” to raise rates, money markets are pricing in a 0.5% increase by the end of the year.

The actions of the central banks are aimed at taming rising inflation. The ECB and Fed are expecting prices to rise by 5.1% and 4.1% in the eurozone and the US, respectively, in 2022, while the Bank of England has warned that UK inflation may reach 8% in the coming months.

The primary drivers of higher headline inflation, according to Capital Economics, are soaring prices in the energy and food sectors. The London-based economic research consultancy forecasts that, on average, Brent crude oil prices will be 56% higher this year compared to 2021, European gas prices will have climbed by 141%, and wheat prices are expected to be up by 40%.

In the EU, energy (for housing and transport) makes up 10% of the consumer price inflation basket, while food accounts for 17%.

Commenting on the perceived effectiveness of recent central bank action, Jason Smith, CIO of Tabula Investment Management, said: “Central banks put off raising interest rates for all of 2021, despite increasing evidence that higher inflation was not transitory. The war in Ukraine has now sparked global pressure on commodity prices: energy, food, and metals. In an already supply-constrained global economy, the recent increases in interest rates in the US and UK won’t solve this supply-side inflation. They are likely too little, too late to bring inflation down to long-term targets and also don’t target the key driver – supply dislocations.”

Amid this challenging environment, Tabula notes that it is receiving increased inquiries from investors on the most effective means to protect their portfolios against inflationary risks.

Michael John Lytle, CEO of Tabula Investment Management, said: “Gold has proven an ineffective hedge, historically, with a correlation to inflation of less than 0.2 over the last 50 years. Meanwhile, baskets of commodities or equities are subject to exogenous factors. We believe the most effective solution to protecting against inflation is to use securities built to specifically track inflation such as TIPS and break-evens.”

Tabula offers up the $90m Tabula US Enhanced Inflation UCITS ETF which is designed to help investors better manage the effects of US inflation by providing access to both realized and expected inflation in a single wrapper.

Highlighting its effectiveness, Tabula notes the ETF has rallied more than 7% since the war in Ukraine began and returned approximately 15% in 2021, outperforming traditional TIPS ETFs by over 9%.

The fund is linked to the Bloomberg Barclays US Enhanced Inflation Index which was developed by Bloomberg, in consultation with Tabula. The index measures the performance of a diversified portfolio of US Treasury Inflation-Protected Securities (TIPS) combined with exposure to medium-term US inflation expectations. The two sleeves are weighted equally.

The TIPS portfolio is composed of securities with at least $500m face value outstanding and at least one year remaining until maturity. TIPS differ from regular Treasury bonds in that the principal amount of a TIPS issue is adjusted over time to reflect changes in the underlying Consumer Price Index, a measure of inflation. The yield on TIPS thus reflects a real interest rate where the effect of inflation has largely been stripped out.

The index’s exposure to inflation expectations is represented by a long position in 7-10 year TIPS and a short position in regular 7-10 year Treasuries to hedge out duration risk. An increase in 7-10 year inflation expectations will lead to a net appreciation in value as increasing inflation expectations cause the yields on regular Treasures to rise and their prices to fall, thus delivering positive performance for the short component of the trade. The short position is adjusted in order to offset the duration exposures of the two indices, thereby establishing a purer play on inflation expectations.

The fund replicates the index by taking a physical position in relevant TIPS and entering into an over-the-counter total return swap agreement in which it receives the return of the inflation expectations portfolio in exchange for agreed payments to the swap counterparty, BNP Paribas.

The ETF is listed on London Stock Exchange in USD unhedged (TINF LN) and GBP-hedged (TING LN) share classes, while EUR-hedged share classes are available on Xetra (TABI GY) and Borsa Italiana (TINE IM) and a CHF-hedged share class is also trading on SIX Swiss Exchange (TINC SW)

The ETF’s unhedged share class comes with ongoing charges of 0.29% while its currency-hedged share classes cost 0.34%.

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