[Macroeconomic Survival Ch. 4] Preparing for Inflation Added More Risk
Rate Hikes Had Paused, but Long Bonds Had Not Risen
By the second half of 2023, the Federal Reserve had effectively stopped raising its policy rate.
The conditions I had been waiting for appeared to be in place. Inflation was below its peak, and the policy-rate target had stopped rising at 5.25%–5.50%. I assumed the remaining possibilities were a prolonged hold or eventual cuts.
TLT and EDV did not respond as I expected.
Long-term market yields rose even while the Fed held its policy rate steady. Inflation remained above the 2% target, and the economy and labor market were stronger than anticipated. Markets began to price the possibility that rates would remain higher for longer.
I had overlooked the distance between “no further increase” and “cuts are coming soon.”
Long-bond prices required long-term yields themselves to fall. Those yields reflected not only the current policy rate, but also expected inflation and growth, Treasury supply, and the term premium.
I thought I had identified the peak in rates. In reality, I had identified only one stage of central-bank policy.
When the account did not recover, I added products instead of reconsidering the thesis.
I Began to Separate Nominal and Real Yields
The vulnerability of EDV and TLT to inflation was clear.
The principal and coupons of the nominal Treasuries they held were fixed in dollar terms. If inflation exceeded expectations, the purchasing power of those future dollars fell. Investors demanded a higher yield as compensation, pushing down the prices of existing nominal bonds.
A useful distinction in understanding the bond market is the difference between nominal yields and real yields.
In a simplified form:
Nominal yield ≈ real yield + expected inflation
The nominal yield is the figure displayed for an ordinary Treasury. The real yield is the return investors demand after accounting for inflation. The difference between nominal and inflation-protected Treasury yields of similar maturities is often used as a market-based gauge of expected inflation.
I concluded that nominal long bonds exposed me to two risks.
- Rising real yields could lower bond prices.
- Rising inflation expectations could put additional upward pressure on nominal yields.
I wanted to separate and hedge at least the inflation component.
That was why I added LTPZ.
LTPZ Was an Inflation-Linked Bond With Long Duration
LTPZ invests in US Treasury Inflation-Protected Securities, or TIPS, with at least fifteen years remaining to maturity.
The principal of a TIPS is adjusted with the US Consumer Price Index. When prices rise, the adjusted principal increases, and coupon payments are calculated using that higher principal. If an individual TIPS is held to maturity, the investor receives the greater of its inflation-adjusted principal or its original principal.
At first, this looked like two forms of protection in one asset.
If inflation accelerated again, the principal adjustment could help. If growth weakened and real yields fell, the long duration could amplify the price gain. I thought the same product might help in both persistent inflation and recession.
That interpretation was too simple.
The principal of a TIPS is adjusted by realized CPI, not by the market's expectation of future inflation. The ETF's market price, however, responds immediately to changes in both expected inflation and real yields.
High inflation alone does not guarantee that LTPZ will rise.
If high inflation is already priced in, or if real yields rise sharply as monetary policy tightens, the loss from long real duration can overwhelm the inflation adjustment. LTPZ's benchmark holds TIPS with long remaining maturities, so the fund itself carries substantial duration.
The phrase inflation-protected did not remove interest-rate risk.
Three Long-Bond Funds Answered Different Questions
EDV, TLT, and LTPZ all hold obligations of the US government, but they are not the same asset.
Understanding their differences made it easier to see which economic conditions each one responds to. The comparison below is deliberately simplified and does not predict an actual ranking of returns.
| Environment | Assets that may be relatively favored | Main reason |
|---|---|---|
| Recession and easing inflation, with nominal and real yields falling | EDV, TLT | Long nominal duration reacts strongly to lower yields |
| Inflation above expectations while real yields remain stable | LTPZ | CPI adjustment and a relative benefit from higher inflation expectations |
| A sharp rise in real yields to contain inflation | No clear winner | LTPZ can also fall sharply because of long real duration |
| Deflation and a severe recession | EDV, TLT | Nominal yields may fall while the inflation adjustment on TIPS weakens |
Building this table made me feel that I understood bonds more clearly.
Understanding more products did not make the portfolio simpler. Adding LTPZ to EDV did not remove risk. It added another variable for me to monitor.
I now had to consider nominal yields, real yields, and expected inflation.
I Increased the Position While Waiting for a Rebound
There was a rationale for adding LTPZ.
The account still felt stagnant. The rebound in long bonds kept receding into the future, while the income I had given up by leaving SGOV remained visible every month.
I began telling myself that the rate cuts had only been delayed; the direction was unchanged.
That statement was only partly useful. Policy rates would eventually fall, but when, by how much, and for what reason would all affect the response of long-term yields and bond prices.
I did not express that uncertainty through a smaller position.
Instead, I interpreted lower long-bond prices as greater future upside. After waiting so long, I felt that an ordinary recovery would not be enough.
That feeling led me to TMF.
TMF Was Not Simply Three Times a Long Bond
TMF seeks 300% of the daily return of an index of US Treasury securities with maturities longer than twenty years.
The structure looked straightforward at first.
If long bonds rose 10% after yields fell, TMF seemed likely to rise 30%. If the direction of rates was clear, I thought I could obtain a larger rebound with less capital than in TLT or EDV.
The most important word in the objective was not three times. It was daily.
TMF does not promise three times the long-term cumulative return of its index. It resets exposure each trading day in pursuit of 300% of that day's return. Performance over longer periods depends on the sequence of daily gains and losses.
The manager itself warns that investors should not expect an exact threefold multiple over periods longer than one day.
I had been thinking about the final direction of rates.
TMF was highly sensitive to the path taken each day along the way.
Repeated Gains and Losses Reduced the Base
The effect of daily reset leverage can be shown with simple numbers.
If an index falls 10% from 100, it ends the day at 90. A gain of about 11.1% the next day returns it to approximately 100.
A triple-leveraged product follows a different path.
- A 30% first-day loss reduces 100 to 70.
- A 33.3% gain on the next day raises 70 only to about 93.3.
- The underlying index has recovered, but the leveraged product still has a loss of roughly 6.7%.
This is often described as volatility drag or the path dependence of compounding. Gains and losses are applied to a changing base each day.
It does not mean a leveraged ETF must always decline over the long run. A strong, persistent move in one direction can cause daily compounding to work favorably.
But even when the eventual direction is right, a volatile route can produce a very different result. Financing costs, fund expenses, and tracking differences add further pressure.
The long-bond market in 2023 did not follow the smooth downward path in yields that I had expected. Bond prices moved sharply whenever expectations changed, and TMF amplified those moves each day.
I thought I was simply waiting for rate cuts.
I was holding a structure in which a longer and more volatile wait could itself become costly.
Leverage Did Not Improve My Forecast
After buying TMF, I became more sensitive to every rate announcement.
A single inflation release, a sentence from a Fed official, or the result of a Treasury auction could move the account substantially. A bond position intended to make the portfolio steadier tied my attention more closely to the market.
As the loss grew, rate cuts began to feel necessary.
At first, I had tried to update my thesis when the data changed. With leverage in the account, I spent more time finding evidence that the position was right than examining why it might be wrong.
Leverage did not make my forecast more accurate. It reduced the time available to think when the forecast was wrong.
EDV is also an aggressive long-duration bond ETF. Its risks, however, differ from those of TMF, which resets a triple exposure each day.
I cannot call EDV safe, but I can explain its primary risk more directly. TMF added the path of volatility and the cost of financing to the direction of rates.
Removing one complex product could be more useful than adding one more hedge.
Prediction Remained After I Reduced Leverage
Looking back at TMF did not leave me with a simple rule that leverage must never be used with bonds.
The deeper problem was that the product did not match the role I had assigned it.
I wanted an asset that would buy time when stocks fell. Instead, I tried to use a fund that reset triple exposure every day as a long-term form of insurance. The purpose and the mechanism did not fit.
I reduced the TMF position and returned to thinking about unleveraged long bonds.
My desire to know the direction of the macroeconomy had not disappeared.
By 2024, markets expected US rate cuts to be drawing closer, while Japan was preparing to leave behind years of negative rates. My attention shifted from one interest rate to the difference between US and Japanese policy—and then to the dollar and the yen.
The next chapter looks at my investment in a fund designed to resemble holding US long bonds in yen. I believed combining two views would diversify risk. Instead, it gave me one more variable to forecast.
Sources Consulted
- US Treasury: TIPS Principal and Interest Adjustments
- US Treasury: TIPS and CPI Data
- SEC Investor Education: Fixed-Rate Bonds and Interest-Rate Risk
- PIMCO and SEC Filing: LTPZ Structure and Principal Risks
- Direxion: TMF's Daily 300% Objective
- SEC Investor Alert: Daily Reset and Longer-Term Risks of Leveraged ETFs
🌊 [Macroeconomic Survival Series]
- Prologue: The Asset I Trusted Most Was the One I Understood Least
- Chapter 1: I Expected Slower Growth in Korea, but the Market Moved on a Different Clock
- Chapter 2: Only After Retreating to Cash Did I Learn the Value of Waiting
- Chapter 3: I Extended Duration While Waiting for the Peak in Rates
- Chapter 4: Preparing for Inflation Added More RiskCurrent
- Chapter 5: I Tried to Forecast Rates and Currencies Together
- Epilogue: Asking Again What My Investing Is For