No Inflation as Yields Jump Belies Point of No Return View

Photographer: Scott Eells/Bloomberg

Treasury 10-year yields rose four basis points, or 0.04 percentage point, to 2.17 last week, as the government reported that the unemployment rate and hourly wages remained steady in May. Close

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Photographer: Scott Eells/Bloomberg

Treasury 10-year yields rose four basis points, or 0.04 percentage point, to 2.17 last week, as the government reported that the unemployment rate and hourly wages remained steady in May.

For the first time since 2009, U.S. bond yields are rising at the same time inflation is slowing, providing a cushion for investors in Treasuries whether or not the Federal Reserve slows the pace of its debt purchases.

While 10-year (USGG10YR) yields reached 2.23 percent May 29, the highest since April 2012, the personal consumption expenditure deflator, the Fed’s preferred gauge of inflation, rose 0.7 percent in April from a year earlier, the smallest increase since 2009. The yield gap between Treasury Inflation-Protected Securities, or TIPS, and non-indexed bonds show investors have cut their expectations for consumer price increases to the lowest level since July.

After losing 2 percent last month, the most since December 2009, according to Bank of America Merrill Lynch bond indexes, Treasuries are offering the highest real yields in more than two years amid 7.6 percent unemployment. The last time yields rose while inflation slowed was four years ago, following President Barack Obama’s $787 billion stimulus plan. Yields later fell.

“We don’t think inflation is a big threat,” Andrew Wickham, head of U.K. and global fixed-income at Insight Investment Management Ltd., which oversees about $134 billion in bonds and currencies, said in a June 5 presentation in London. “It is very unlikely that we will see any major rise in interest rates for Treasuries from here.”

Bonds Rally

Wickham said he’s buying Treasuries maturing in 30 years, which would typically suffer the biggest losses if inflation accelerates, while selling those due in 10 years.

Treasury 10-year yields rose four basis points, or 0.04 percentage point, to 2.17 last week, as the government reported that the unemployment rate and hourly wages remained steady in May. Yields on 30-year (USGG30YR) bonds increased five basis points to 3.34 percent. The price of the benchmark 1.75 percent note due May 2023 dropped 12/32, or $3.75 per $1,000 face value, to 96 7/32. Yields rose five basis points to 2.22 percent at 12:36 p.m. New York time.

The 10-year Treasury yield reached as high as 2.23 percent on May 29, up from 1.67 percent at the end of April amid growing expectations that the Fed will begin to reduce, or taper, its $85 billion monthly purchases of Treasuries and mortgage bonds.

Bill Gross, manager of the world’s biggest fixed-income fund for Pacific Investment Management Co., said in a May 10 Twitter message that the 30-year bull market for bonds had “likely ended” as yields reached a low.

‘Feel Sorry’

“I feel sorry for people that have clung to fixed-dollar investments,” Warren Buffett, chairman of Berkshire Hathaway (BRK/A) Inc., said at the company’s May 4 shareholders meeting in Omaha, Nebraska. Savers depending on bond payments are “victims” of policies to lower borrowing costs, he said.

Fed officials led by Chairman Ben S. Bernanke will trim bond purchases to $65 billion a month at the Oct. 29-30 meeting of the Federal Open Market Committee, from the current level of $85 billion, according to the median estimate in a survey of 59 economists last week. In a similar survey before the central bank’s April 30-May 1 meeting, economists expected it to cut buying to $50 billion in the fourth quarter.

Policy makers remain divided over the next steps for stimulating the world’s biggest economy. Philadelphia Fed President Charles Plosser has called for tapering the bond purchases that have pumped more than $2.8 trillion into the financial system as soon as the central bank’s next meeting on June 18-19.

Fiscal Drag

New York Fed President William C. Dudley said in an interview with Bloomberg News in May he would like to wait three or four months to see “how the tug-of-war between the fiscal drag and the improving economy are going to sort of work their way out.”

Inflation across developed economies rose 1.3 percent in April, the least since 2009, the Paris-based Organization for Economic Cooperation and Development said June 4. Consumer price rises in May were less than forecast in eight of 10 countries tracked by the Citigroup Inflation Surprise indexes.

Arguing that yields should be higher “would be easier if there were some inflation,” Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York, said in a June 3 telephone interview.

Consumer prices are being held down in part by the slowest velocity of money in March since at least 1959, according to data compiled by Bloomberg. The gauge measures the rate at which cash changes hands, dividing GDP by the Fed’s M2 measure of money supply.

Break-Even Rate

The gap in yields between TIPS and U.S. government debt not indexed for inflation, known as the break-even rate that shows investor expectations for the consumer price index over the life of the bonds, narrowed last week to 2.15 percentage points, the lowest on a closing basis since July, from 2.59 percentage points on March 14.

Real yields on 10-year Treasuries after subtracting the PCE deflator index, was 1.43 percent last week, about the highest since April 2011, and up from 0.18 percentage point less than inflation in November.

That’s still too low, according to Donald Ellenberger, who oversees about $10 billion as co-head of government and mortgage-backed securities at Federated Investors in Pittsburgh.

“There’s not enough value yet in Treasury yields to make them a good buy relative to other fixed-income asset classes,” Ellenberger said in a June 5 telephone interview. “Inflation is a lagging indicator” and tends to rise two years after the start of a “normal” recovery.

Corporate Yields

Federated is buying investment grade and high-yield company debt as well as commercial mortgage-backed securities, he said. Company debt yields about 2.23 percentage points more than Treasuries, according to the Bank of America Merrill Lynch U.S. Corporate & High Yield Index.

Unemployment in the U.S. rose to 7.6 percent in May as the economy created 175,000 jobs, more than the forecast of 163,000 in a Bloomberg survey. While the jobless rate is down from 7.9 percent in October, it’s above the Fed’s goal of 6.5 percent before the central bank would consider raising the record-low benchmark interest rate of zero to 0.25 percent it has maintained since December 2008.

Average hourly earnings were flat in May, the Labor Department said. Total U.S. wages amount to 43.8 percent of U.S. economic output, the lowest since at least 1947, data from the Fed Bank of St. Louis show.

Stock Gains

The Standard & Poor’s 500 index rose 0.8 percent last week. The 16 percent gain for the year helped push household wealth up 4.5 percent in the first quarter, the central bank reported June 6. Consumer confidence increased to the highest since 2008.

“If the Fed pulls back from purchases too quickly the equity market is going to take a big hit and that is going to have a depressive effect on consumer confidence and could slow growth even further,” Thomas Simons, a government-debt economist in New York at Jefferies LLC, one of the 21 primary dealers that trade with the central bank, said in a June 3 telephone interview.

Yields rose amid declining consumer prices from September 2005 through June 2007 as Fed interest-rate increases and surging leveraged buyouts and rising real estate activity pushed Treasury yields to a five-year high of 5.29 percent from 4.01 percent even as the PCE deflator dropped to 2.5 percent from 3.9 percent.

Asset Purchases

Treasuries rallied after the Fed ended its two previous asset purchase programs in March 2010 and June 2011. The 10-year yield fell 1.36 percentage points to 2.47 percent in the five months through August 2010 on concern the economy faced the rising risk of deflation, or persistent price decreases.

Yields declined 1.09 percentage points to 2.07 percent over the five months ended Nov. 30, 2011, as investors sought the safety of Treasuries after S&P cut the credit rating of the U.S. to AA+ from AAA and as Europe’s sovereign debt crisis worsened.

“We’ve seen this before,” James Kochan, chief fixed-income strategist at Wells Fargo Funds Management LLC in Menomonee Falls, Wisconsin, said in a June 4 telephone interview. Calls for the Fed to announce it will scale back bond purchases after its June 18-19 meeting are “bordering on the silly” with the economy struggling to grow at a 2 percent pace, he said.

While Kochan said 10-year yields will remain in a range between 1.75 percent and 2.25 percent, he recommends investment grade and high-yield corporate debt and bonds of U.S. state and local governments.

Growth Forecasts

The U.S. economy is forecast to grow 1.9 percent this year and 2.7 percent in 2014, according to the median estimate of 82 economists in a Bloomberg News survey.

Treasuries are attractive based on the market’s “too optimistic reading,” of economic growth rather than the current low rate of inflation, Robert Tipp, the chief investment strategist in Newark, New Jersey, at Prudential Financial’s fixed-income division, which oversees $395 billion in bonds.

A decision by the Fed to reduce bond purchases prematurely risks “jeopardizing the positive wealth effect they have working for them and the momentum the economy has,” Tipp said in a June 5 telephone interview.

“Normally when yields rise, inflation expectations tend to rise at the same time,” Anton Heese, global head of inflation research in London at Morgan Stanley, said in a June 4 telephone interview. “The difference this time is that the market seems to suggest through the price action that we might get a recovery with moderate or no real increase in inflation.”

To contact the reporters on this story: Daniel Kruger in New York at dkruger1@bloomberg.net; Anchalee Worrachate in London at aworrachate@bloomberg.net

To contact the editor responsible for this story: Dave Liedtka at dliedtka@bloomberg.net

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