Tags: Bond | Market | Fed | You | Wrong | About | Inflation

Bond Market to Fed: You're Wrong About Inflation

Tuesday, 15 Feb 2011 10:51 AM

 

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Listen up, Fed, because the bond market has something very important to tell you: Inflation is a problem and you're making it worse.

Bond investors are piling into bets that will pay big if inflation takes off — short selling everything from interest rate futures to long bonds while snapping up securities that offer protection from price growth.

After the beating they suffered on similar bets a year ago, these investors think the U.S. central bank has turned a blind eye on inflation, asserting high unemployment will damp price growth. These inflation fighters find support in improving economic growth and high oil and food prices. They also see the Fed's near zero-rate policy fueling future inflation.

And, the bond market is now moving in their direction. Treasurys fell in eight out of the last 11 sessions, pushing benchmark 10-year yields to 9-1/2 month highs last week.

"The good news on inflation is behind us," Ken Volpert, head of the taxable bond group with the Vanguard Group in Valley Forge, Pennsylvania, told Reuters. Volpert, one of the biggest U.S. bond managers, oversees $360 billion in assets.

 FLASHING RED

The change in sentiment has been striking. Three months ago, interest rate futures factored in virtually no chance of a rate increase. Now, traders have priced in a 93 percent chance that the Fed will raise interest rates in December, which would be the first rate increase in five years.

This comes with the shift in inflation perceptions. One closely watched gauge, the Treasury Inflation-Protected Securities (TIPS) market, is flashing warning signals.

The yield spread or "breakeven" rate between 10-year TIPS and regular 10-year Treasurys has grown to 2.30 percentage points after hitting its highest in about a year in January.

That reading last August was about 1.50 percentage points before Fed Chairman Bernanke signaled he would pump cash into the economy with a second round of large-scale bond purchases.

Similarly, the gap between two-year and 10-year Treasury yields — another sentiment barometer on inflation — has widened to 2.76 percentage points from 2.00 percentage points, not far from record highs which neared 3.00 percentage points on February 4.

GIMME SHELTER

Rising prices and a less easy Fed "can spell disaster for bonds," said Mike Ruff, portfolio manager with Russell Investments in Seattle, which manages $155 billion in assets.

Investors have poured money into stocks, gold and other investments to achieve higher returns and to hedge against inflation. They have poured $22 billion into TIPS funds since the start of 2008, according to Thomson Reuters' Lipper service.

Investor appetite for inflation protection will be tested Thursday when the U.S. sells $9 billion of 30-year TIPS.

Less than a year ago, traders who were bearish on bonds took a bath on their rising-inflation bets as the European debt crisis and fear of deflation emerged. The Fed responded by launching its $600 billion bond-buying spree.

Now the threat of falling prices has abated, but Bernanke and most of his colleagues say there's little evidence the trend will reverse any time soon.

Sure, gasoline and other commodity prices are rising, Bernanke acknowledged last week before a Congressional panel.

"Nonetheless, overall inflation is still quite low and longer-term inflation expectations have remained stable," he said Feb. 9. Inflation expectations as measured by TIPS have risen, he said, but only from "low to more normal levels."

DATA BACK FED ... SO FAR

Indeed, the inflation data are backing up the Fed.

The core rate on personal consumption expenditure, the Fed's preferred inflation gauge, eked out a 0.70 percent rise in 2010, the smallest annual rise on record.

To the majority of Fed officials, inflation is not likely to be a problem so long as unemployment — at 9 percent in January — remains high.

As John Williams, head of research at the San Francisco Fed put it, "Millions of people could be put back to work and many more goods and services could be produced without igniting unwelcome inflation."

But some investors are betting that an upturn in inflation will take off faster than what the Fed expects if the economy continues to accelerate, even as the Fed views inflation, without food and oil, as benign.

"Real-life inflation is going up, even if it won't be as bad as some bond bears think," Carl Kaufman, portfolio manager at Osterweis Capital Management in San Francisco, which oversees $5 billion in assets.

© 2014 Thomson/Reuters. All rights reserved.

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