Deflation Disappears With Bond Market Showing Growth
Ben S. Bernanke, chairman of the U.S. Federal Reserve
Tomohiro Ohsumi/Bloomberg
Ben S. Bernanke, chairman of the U.S. Federal Reserve.
Ben S. Bernanke, chairman of the U.S. Federal Reserve. Photographer: Tomohiro Ohsumi/Bloomberg
The bond market is showing Federal Reserve Chairman Ben S. Bernanke will succeed in sparking inflation after the smallest gain in core consumer prices in half a century increased concerns that the economy will deflate.
Expectations for rising consumer prices have increased faster in the U.S. than any other bond market this month as central bankers made the case for monetary easing through additional asset purchases. Yields on 30-year Treasuries climbed as much as half a percentage point since September to 2.61 percentage points more than similar maturity inflation-indexed debt, the widest gap since May and an indication for anticipated gains in consumer prices.
While central banks are typically more concerned about faster inflation, the worst financial crisis since the Great Depression has made sustained price declines a bigger concern. Fed policy makers, who already cut interest rates almost to zero and bought $1.7 trillion of securities, are discussing more purchases of Treasuries to flood markets with cheap money as well as strategies for raising inflation expectations to prevent stagnating prices from undermining the recovery.
“It’s like a Harry Potter movie,” said Mitchell Stapley, the chief fixed-income officer for Fifth Third Asset Management, referring to the films based on the best-selling novels about the adolescent wizard by J.K. Rowling. “They create money out of nothing. Over the short-term there might not be an impact, but certainly we are feeling that at some point they will get traction. There will be success further down the road.”
Consumer Prices
Stapley, who helps manage $22 billion in Grand Rapids, Michigan, has been buying Treasury Inflation-Protected Securities, or TIPS, even though the Labor Department reported on Oct. 15 a smaller-than-forecast increase of 0.1 percent in the cost of living for September.
Core prices, which exclude food and fuel, were little changed in September, capping a 0.8 percent increase in the past 12 months, the smallest year-over-year gain since 1961.
Demand for TIPS is increasing as investors buy insurance in case inflation, which erodes the value of fixed-rate payments on bonds, accelerates after the Fed gets the economy back on track. U.S. gross domestic product expanded at a 1.7 percent annual rate in the second quarter.
“I actually see the prospects of inflation returning to about 2 percent over the course of the next year, gradually rising,” Federal Reserve Bank of Philadelphia President Charles Plosser said at an event in Philadelphia on Oct. 22. The “kindling” is already in place for higher inflation, he said.
Breakeven Rates
The difference between yields on 30-year TIPS and Treasuries -- which represents the annual inflation rate investors anticipate over the life of the securities -- tumbled to a record low of 0.57 percentage point, or 57 basis points, in November 2008 as the financial crisis spurred concern falling prices of assets such as homes would spawn deflation, making consumers and businesses less willing to spend or invest.
The so-called breakeven rate, which has averaged about 2.30 percent since the U.S. began selling 30-year TIPS in 1998, was as low as 1.84 percentage points on Aug. 25. The measure was little changed at 2.54 percentage points at 10:06 a.m. in New York.
More stimulus may be needed because inflation is too low and unemployment too high at 9.6 percent, Bernanke said on Oct. 15 at the Federal Reserve Bank of Boston. Charles Evans, Dennis Lockhart and William Dudley, presidents of the Fed banks in Chicago, Atlanta and New York, said policy makers will start a second round of unconventional stimulus, with Evans and Lockhart saying asset purchases must be big enough to aid growth.
Fed Purchases
While inflation expectations are building, traders and analysts anticipate Fed purchases of Treasuries due in 10 years or less to keep borrowing costs down. A Bloomberg News survey showed all 18 of the primary dealers that act as counterparties with the Fed expect Treasury purchases next month.
Citigroup Global Markets Inc. strategists said last week they expect $500 billion to $700 billion. Alan Blinder, a former vice chairman of the Fed, said $500 billion is “too small.”
The yield premium investors demand to own 30-year bonds instead of 10-year notes reached a record high of 1.46 percentage points on Oct. 15, before easing to 1.38 percentage points last week. The five-year average is 0.52 point, according to Bloomberg data.
A steeper so-called yield curve is historically a sign bond investors anticipate faster economic growth. The relationship between short- and long-term yields suggests an 18.5 percent chance of another recession, according to a September report from the Federal Reserve Bank of Cleveland.
Bond Losses
“It’s very hard in a mathematical sense to lower Treasury yields and increase inflation expectations,” said Brian Weinstein, who oversees inflation-linked bond investments in New York at BlackRock Inc., the world’s biggest asset manager. “There has to be some sort of consequence. So far that consequence has been a steeper yield curve.”
Bonds due in 30 years are the worst-performing Treasuries in October, losing 4.04 percent, according to Bank of America Merrill Lynch index data. The securities are posting the biggest monthly loss since December because longer-maturity debt is more at risk when inflation accelerates with investors locked into fixed-rate payments for a greater period of time.
“The information content of the Treasury curve is somewhat polluted because you have the tinkering of quantitative easing,” said Gregory Peters, global head of fixed-income research in New York at Morgan Stanley. “All the inflation expectations manifest themselves in the 30-year.”
Fed Measure
A chart the Fed uses that plots forward rates measuring expectations for inflation in five years also shows investors are beginning to grow concerned. The so-called five-year, five- year forward rate increased to 2.81 percent on Oct. 15 after touching a near two-year low of 2.17 percent on Aug. 24. The rate, which is based on trading in TIPS, averaged 2.6 percent the five years before the financial crisis began.
Inflation has yet to hit consumers. Minneapolis-based Target Corp., the second-largest discount retailer, said Oct. 7 that it would cut prices on more than 1,000 toys. Bentonville, Arkansas-based Wal-Mart Stores Inc., the biggest, responded Oct. 13 with its own discounts, advertising savings on brands such as Barbie and Nerf toys.
Pacific Investment Management Co.’s Bill Gross, manager of the world’s largest bond mutual fund, said the Fed should aim for an inflation rate of 2.5 percent to 3 percent.
Cutting Back
“If and when we do that, then that’s a very favorable type of proposal for risk assets that wheel off inflation, in other words stocks,” Gross said in an Oct. 8 interview with Bloomberg Television. The risk of the Fed triggering hyper-inflation that would be hard to control is “years” away, he said. “I don’t have any concerns, and I don’t think the Fed does, either.”
Gross reduced holdings of government-related debt in the $252 billion Total Return Fund to 33 percent of assets in September, the least in six months, according to data posted Oct. 15 on the website of Newport Beach, California-based Pimco.
Low borrowing costs have done little to spur home buying with the jobless rate at about the highest level in two decades. Sales of existing houses were the second-lowest on record in August, the National Association of Realtors in Washington said.
The housing market remains an impediment to the Fed’s efforts, even as rates for 30-year mortgages fell to 4.19 percent in the week ended Oct. 14, the lowest rate since McLean, Virginia-based mortgage-finance company Freddie Mac began tracking the data in 1971.
‘Positive Growth’
“We are in a positive growth environment, it’s just not enough yet to push the unemployment rate down, at least as fast as the Fed would like,” said Michael Pond, an interest-rate strategist in New York at Barclays Plc.
The Commerce Department will say Oct. 29 that the economy grew at a 2.1 percent rate in the third quarter, according to median forecast of 20 economists in a Bloomberg News survey.
“Perhaps it’s the beginning of people thinking not just about yield, and where can I get yield, but it’s remembering that the additional yield comes with greater inflation risk,” said James Sarni, senior managing partner at Payden & Rygel in Los Angeles, which manages $55 billion. He has been buying higher yielding sovereign debt from emerging market nations.
“They’re now targeting a certain inflation rate,” Sarni said of the Fed. “If they’re targeting 2 percent, there’s a risk of overshoot, and what does it overshoot to?”
To contact the reporter on this story: Daniel Kruger in New York at dkruger1@bloomberg.net
To contact the editor responsible for this story: Dave Liedtka at dliedtka@bloomberg.net
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