TIPS Give Bernanke Green Light to Ease Amid Record Yields
Bond traders are cutting expectations for U.S. inflation by the most since December, providing Federal Reserve Chairman Ben S. Bernanke the scope for additional stimulus as the central bank’s current effort winds down.
With six weeks left before the end of the Fed’s $400 billion swap of short-term debt for longer-term securities in a program known as Operation Twist, everything from yields on securities that protect against rising consumer prices to a measure of the outlook for inflation in the forwards market show diminished concerns. Traders are pricing in a 55 percent chance that the central bank will begin new efforts to spur economic growth, Bank of America Corp. says.
Speculation has risen that the central bank may need to add to the $12.8 trillion already spent to avert a second recession in three years after reports showed jobs are growing more slowly than forecast and Bernanke said April 25 that the Fed remains “prepared to do more as needed.” For first time since it announced Operation Twist in September, the Fed’s preferred gauge of measuring traders’ inflation expectations is poised to fall for a second straight month.
“It’s not only a weak economy, but as inflation comes down, it could be another reason for the Fed to implement some more stimulus,” said Gary Pollack, head of fixed-income trading at Deutsche Bank AG’s Private Wealth Management unit in New York, which manages $12 billion, in a May 14 interview.
Record Low Forecast
Deutsche Bank’s investment banking unit and JPMorgan Chase Co. expect yields on the benchmark 10-year note will tumble to a record 1.5 percent this year, from 1.72 percent last week and this year’s high of 2.4 percent on March 20. The previous low of 1.67 percent was reached Sept. 23. It has averaged 3.82 percent over the past 10 years.
“Growth concerns have increased, and with the drop in commodity prices inflation concerns have decreased which has kept the environment friendly for low rates,” said Michael Pond, co-head of interest-rate strategy in New York at Barclays Plc, one of the Fed’s 21 primary dealers. “If growth stalls, the employment rate stops falling and inflation remains no concern, it won’t take much for another round of stimulus.”
Gross domestic product rose at a 2.2 percent annual rate last quarter, according to the Commerce Department. That followed a 3 percent pace in the three months ended Dec. 31. The average was 2.6 percent from 2000 to 2007, before the financial crisis.
Yields on 10-year notes fell 12 basis points last week, or 0.12 percentage point, to 1.72 percent, Bloomberg Bond Trader prices show. The 1.75 percent security due May 2022 rose 1 1/32, or $10.31 per $1,000 face amount, to 100 7/32. The yield was two basis points higher at 1.74 percent at 10:59 a.m. New York time.
Treasuries have rallied for nine straight weeks, the longest stretch since October 1998, as Europe’s debt crisis flared and concern rose that the recovery may be faltering.
Treasuries due in 10 years have returned 6.71 percent since yields peaked this year on March 20, according to Bank of America Merrill Lynch index data. That compares with a loss of 7.52 percent after dividends for the Standard & Poor’s 500 Index and a plunge of 10.3 percent in the S&P Total Return Index of metals, fuels and agricultural products.
Other benchmark bond markets are also reaching record low yields. German 10-year bunds dropped to 1.396 percent on May 18. U.K. gilts of similar maturity fell to 1.81 percent last week, data compiled by Bloomberg show.
Inflation in the U.S. last month grew at the slowest pace since February 2011, the Labor Department said May 15 in Washington. The consumer price index rose 2.3 percent in April from a year earlier, down from 2.7 percent the previous month.
The difference in yields between 10-year notes and Treasury Inflation Protected Securities, or TIPS, which represents traders’ expectations for the rate of inflation over the life of the bonds, fell to 2.04 percentage points on May 17. That’s the least since Jan. 23, and down from the high this year of 2.45 percentage points on March 20.
“We’ll probably have to go below 2 percent on 10-year break-evens for the Fed to say there’s a higher chance of deflation priced in,” Priya Misra, head of U.S. rates strategy at primary dealer Bank of America Merrill Lynch in New York, said in a May 14 telephone interview. ”This paves the way for more stimulus, but we’re not there yet.”
A measure of price-increase predictions used by the Fed to set policy, the five-year, five-year forward break-even rate, which gauges the average inflation rate between 2017 and 2022, dropped to 2.43 percent on May 16, from a 2012 high of 2.78 percent on March 19. The rate slid nine basis points in April, the biggest monthly decline since December.
The Fed purchased $1.4 trillion in mortgages and $900 billion of Treasury debt in two rounds of quantitative easing, that have become known as QE1 and QE2, beginning in November 2008, to avert a prolonged decline in prices, or deflation, and to boost the economy from the recession that ended in June 2009.
A model used by the Federal Reserve Bank of Cleveland, which includes movements in Treasury yields, survey forecasts of price increases and swap rates, predicts that inflation will average 1.2 percent over the next five years and 1.4 percent over the next 10 years.
“In late-2010, when the Fed implemented its second round of quantitative easing, these measures of expected inflation had also collapsed and were running well below 2 percent,” Sam Bullard, a senior economist at Wells Fargo Securities LLC in Charlotte, North Carolina, wrote in a May 16 note to clients. “Policy makers will probably need to see more negative news before acting, especially during an election year.”
While the amount of marketable Treasuries outstanding has more than doubled to $10.3 trillion from $4.4 trillion in mid- 2007, debt expense equaled 3 percent of the economy in fiscal 2011 ended Sept. 30, down from 4 percent in 1999, when the U.S. ran budget surpluses.
Further stimulus carries political risks. Republican lawmakers and economists wrote an “Open Letter to Ben Bernanke” on Nov. 15, 2010, opposing QE2 and disagreeing with the view that inflation should be pushed higher. GOP presidential contender Mitt Romney said in September he would replace the Fed chief if elected.
Minutes of the Fed’s Open Market Committee April meeting, published May 16, showed several policy makers said additional action could be necessary if the recovery slips.
“It’s entirely possible the Fed will have a difficult decision to make right around the time of the election and that makes their job even trickier because of potential accusations of politics playing a role,” Jeffrey Caughron, a partner at Baker Group LP in Oklahoma City who advises community banks on investments of more than $30 billion, said in a May 16 telephone interview. “That puts both Bernanke and Obama in a difficult position.”
The economy is already showing signs of weakening. Employers in the U.S. added fewer jobs than forecast in April as payrolls climbed by 115,000, the smallest gain in six months, Labor Department figures showed May 4 in Washington. The figure compared with a 160,000 median estimate of 85 economists surveyed by Bloomberg News.
More Action Needed
Even as the jobless rate fell to a three-year low, wage growth slowed to 1.8 percent in April from a year earlier. Hourly earnings have risen 1.9 percent on average since the start of 2010, down from 2.7 percent in 2009, 3.2 percent in 2008 and 3.5 percent in 2007, Labor Department data show.
The U.S. faces a potential economic crunch at year-end when tax increases and spending cuts to narrow the budget deficit are slated to kick in unless Congress takes action to block them.
The combined impact of the changes amounts to about 4 percentage points of gross domestic product, Federal Reserve Governor Elizabeth Duke said May 15 in Washington.
“The economy isn’t healing on its own,” Mihir Worah, a managing director at Pacific Investment Management Co. in charge of $105 billion in investments aimed at generating returns higher than inflation, said in a telephone interview May 15. “More action from the Fed is needed. Without the Fed we are likely to see more volatility and investor insecurity, all of which takes us further from a self-sustaining path.”
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