Rising Inflation Fuels Demand For TIPS ETFs

Growing inflationary pressures are bothering Americans as cost of living in the United States has risen steadily on higher gas prices. This is especially true given that inflation has been trending above the Fed’s 2% target over the past few months. The latest data showed that it accelerated at the fastest pace in more than six years in May. The Consumer Price Index rose 0.2% in May, bringing the annual inflation (12 months through May) to 2.8% -- the biggest gain since February 2012 and following a 2.5% increase in April.

The trend is likely to continue in the coming months given that the economy has expanded for nine years and the United States has now entered its second-longest expansion phase since 1785. After two months of lackluster gains, hiring in the United States rebounded with the addition of more-than-expected 223,000 jobs in May. Unemployment dropped from 3.9% to 3.8%, the lowest since 2000 while average hourly wages rose eight cents, pushing the year over year increase to 2.7%.

This has sparked a record $1.2 billion inflows into the top 10 ETFs focused on Treasury Inflation Protected Securities (TIPS) last week that hedge against the risk of inflation according to a JPMorgan Chase. Over the past two weeks, these TIPS ETFs have accumulated $1.74 billion in capital.

Why TIPS ETFs?

TIPS ETFs offer shelter against rising inflation. It not only combats increasing prices but also protects income for the long term. To explain in details, consider a fixed interest rate of 2.0% on five-year TIPS with initial face value of $1,000. In the first six months when inflation is zero, the semi-annual interest payment would be $10 but when inflation rises 5% annually in the next six months, the semi-annual interest rate would be $10.25 (1,025*2%-1/2 = 10.25).

This is because TIPS pays interest on an inflated-principal amount (principal rises with inflation) and in this case principal becomes $1,025 when the semi-annual inflation is accounted for. As a result, both principal amount and interest payments will go on rising with increasing consumer prices.

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