Reason for the recent large drop in TIPS bonds

The 90-day chart shows the huge sell-off in Treasury Inflation Protected Securities (TIPS). The iShares TIPS ETF is off over 6% since mid-March, while the U.S. Bond Market Index (Barclays Aggregate, AGG) is off about 2%.

The drop in the TIPS has mainly been driven by the increase in yields on the 10 Year U.S. Treasury, which has seen yields rise by almost 100 basis points over the same time period. Much of the increase in the 10 Year Treasury yield is the result of expectations that the Federal Reserve Bank will start tapering down its quantitative easing program in the near future. This was somewhat confirmed this week, when Fed Chairman Ben Bernanke said that if economic data continues to come improve, the Fed will begin to scale back the level of bond and mortgage purchases later this year, and could end the asset purchases entirely by mid-year 2014. 

But the jump in nominal Treasury yields does not fully explain the recent increase in TIPS yields. The yields on TIPS are driven by two primary forces: nominal yields and inflationary expectations. Therefore, the increase in TIPS yields not explained by the increase in nominal bond yields is primarily attributable to falling inflationary expectations. 

It appears that the Fed’s quantitative easing program has been able to prevent deflation from occurring in the U.S. economy (i.e. increasing inflation). The simultaneous combination of higher nominal Treasury bond yields and falling inflationary expectations are the factors that led to the significant losses in TIPS over the past several weeks.