Fed’s Inflation Gauge Reveals 2008 High a Distant Threat

US President Barack Obama
Barack Obama, U.S. president, needs the support of the bond market to help finance a budget deficit projected to exceed $1 trillion for the fourth year. Photographer: SeongJoon Cho/Bloomberg

Even after the worst rout since 2010, the U.S. bond market shows the economy is unlikely to maintain its strength without help from the Federal Reserve.

While the Fed triggered this month’s 2.2 percent loss in 10-year Treasuries when policy makers raised their assessment of the economy following a March 13 meeting, everything from derivatives to mortgage securities indicates that investors don’t expect a repeat of the bear markets seen in 1994 and 2009, two of the worst years ever for bonds.

Declining unemployment, rising consumer confidence and strength in manufacturing may give way to more sluggish growth as George W. Bush-era tax breaks end and $1 trillion of mandatory federal budget cuts kick in. Even with oil back above $100 a barrel, the Fed’s preferred measure of gauging the outlook for inflation shows consumer prices will rise at half the pace of 2008 when it accelerated to 5.6 percent.

“We’ve seen this story in 2010 and 2011, where it looks pretty good in the first half and then we have to change our tune in the second half,” said Robert Tipp, the chief investment strategist in Newark, New Jersey, at Prudential Financial Inc., which oversees $300 billion in bonds.

Tipp spoke in a March 20 telephone interview, the same day that 10-year Treasury yields rose to 2.4 percent, the highest level since October. Prudential favors corporate bonds and longer-term debt, expecting yields to fall, he said.

Rising Debt Load

President Barack Obama needs the support of the bond market to help finance a budget deficit projected to exceed $1 trillion for the fourth year. U.S. borrowing costs have remained low even though the amount of marketable debt outstanding has more than doubled to $10.2 trillion from $4.34 trillion in mid-2007 as the government sold bonds to pay for spending programs designed to pull the economy out of the worst financial crisis since the Great Depression.

The Fed and Chairman Ben S. Bernanke helped by cutting interest rates to a record low of zero to 0.25 percent, and purchasing $2.3 trillion of bonds in two rounds of policy called quantitative easing, or QE.

Bill Gross, who runs the world’s biggest bond fund at Pacific Investment Management Co., said the central bank will probably signal plans to arrange a third round of debt purchases when policy makers meet in April. The Fed is “likely to hint” at QE3 at its April 25 gathering, Gross wrote on Twitter.

No ‘Easing Up’

Housing reports last week showed a key part of the economy remains under pressure. The Commerce Department said March 23 new home sales fell to a 313,000 annual pace in February, the slowest since October, from the 318,000 rate in January that was weaker than previously reported. Earlier in the week the National Association of Realtors said existing-home sales eased to a 4.59 million rate last month from January’s 4.63 million.

“It’s hard for me to imagine that they’re going risk seeing the economy decelerate in the second half as a result of them easing up on stimulus,” Prudential’s Tipp said in reference to the Fed and speculation the central bank may need to tighten monetary policy sooner than 2014 to contain inflation.

Bonds rebounded last week, with benchmark 10-year note yields falling five basis points, or 0.05 percentage point, to 2.23 percent, according to Bloomberg Bond Trader prices. It was four basis points higher at 2.27 percent at 8:13 a.m. New York time. The 2 percent security due February 2022 fell 10/32, or $3.13 per $1,000 face amount, to 97 20/32.

‘Desperate for Yield’

Ten-year yields are up from 1.97 percent at the end of February, and this year’s low of 1.79 percent on Jan. 31. Investors in Treasuries have lost 1.4 percent this quarter including reinvested interest, set for the biggest drop since losing 2.67 percent in the final three months of 2010, the Bank of America Merrill Lynch U.S. Treasury Master Index shows.

“People are desperate for yield, and Treasuries don’t have yield,” Donald Ellenberger, who oversees about $10 billion as co-head of government and mortgage-backed securities at Federated Investors Inc. in Pittsburgh, said in a March 22 telephone interview. “Instead of being the risk-free rate, they’re return-free risk right now.”

Federated insulated itself from the losses by shifting to an underweight position in Treasuries at the end of 2011, meaning it owns a smaller percentage of the securities than is contained in benchmark indexes, Ellenberger said.

Signs that the economy is gaining traction have led investors to shun bonds in favor of riskier assets such as stocks. The Standard & Poor’s 500 index advanced 11.6 percent this year, including dividends.

Recovery Signs

Reports in the past month have shown the unemployment rate falling to 8.3 percent, the lowest level since February 2009, the Bloomberg Consumer Comfort Index rising to a four-year high and the Institute for Supply Management’s factory index signaling an expansion in manufacturing for the 31st straight month.

The Federal Open Market Committee said in a statement at the conclusion of its March 13 meeting in Washington that it now expects “moderate economic growth” and predicted the unemployment rate “will decline gradually.” In its prior statement in January, the FOMC said growth would be “modest” and unemployment “will decline only gradually.”

Fed’s Preferred Gauge

It also said oil will “push up inflation temporarily, but the committee anticipates that subsequently inflation will run at or below the rate that it judges most consistent with its dual mandate” of promoting maximum employment and stable prices.

The bond market agrees. The five-year, five-year forward breakeven rate, which projects the pace of consumer price increases starting in 2017, ended last week at 2.73 percent.

While the measure, which the Fed prefers to look at in determining inflation expectations and monetary policy, is up from this year’s low of 2.37 percent on March 5, it’s in line with the average over the past decade. It’s also below the 3.63 percent level reached in the wake of Lehman Brothers Holding Inc.’s collapse on speculation the Fed would flood the economy with cash and spark runaway inflation.

The difference between yields on 10- and 30-year Treasuries also suggests less concern about faster inflation. Amid the selloff the gap has shrunk to 1.07 percentage points from this year’s peak of 1.2 percentage points on Feb. 3.

Annual Losses

The spread typically widens when traders are concerned that inflation will accelerate because investors demand more compensation to own long-term bonds. In 2008, when the consumer price index rose to 5.6 percent from 2 percent in 2007, the gap in yields expanded to 1.01 percentage points from about 0.08 percentage point.

Improvements in the labor market have yet to spur wage inflation. Average hourly earnings rose 1.9 percent in February from a year earlier, down from an average of 3.2 percent in 2008 and 3.7 percent in January 2009, Labor Department data show.

While he’s encouraged by the unemployment rate’s decline, continued accommodative monetary policy will be needed to make further progress, Bernanke said today.

The drop in unemployment may reflect “a reversal of the unusually large layoffs that occurred during late 2008 and over 2009,” Bernanke said in a speech in Arlington, Virginia. “To the extent that this reversal has been completed, further significant improvements in the unemployment rate will likely require a more-apid expansion of production and demand from consumers and businesses, a process that can be supported by continued accommodative policies.”

Most Accurate

The Treasury market posted annual losses only three times over the past 30 years, according to the Bank of America Merrill Lynch indexes. The last time was in 2009, when it tumbled 3.72 percent as the S&P 500 soared 23.5 percent.

In 1999, the market lost 2.38 percent as the Fed raised its target rate for overnight loans between banks to 5.5 percent from 4.75 percent. Losses totaled 3.35 percent in 1994 as the central bank boosted rates to 6 percent from 3 percent.

For the most accurate forecaster of Treasury yields, 2012 will probably look more like 2010 and 2011, when bonds tumbled early before recovering as growth slowed.

“The employment data will probably stay strong up until May,” Christopher Low, the chief economist at FTN Financial in New York, said in a March 16 interview. “After that, I don’t think it can be sustained. People tend to start hiring more in the spring time.”

Low, who was the only one among 70 analysts in a Bloomberg survey at the start of 2011 who predicted 10-year yields would fall to 2 percent by the end of that year, said they will remain in a range of 1.8 percent to 2.3 percent in 2012.

Gross domestic product will expand 2.2 percent this year, according to a Bloomberg News survey of 72 economists. That’s slower than the 3.1 percent posted in 2005 and 2.7 percent in 2006 before the recession and financial crisis.

Hedging Costs Fall

Traders are paying less to hedge against rising 10-year yields during the next three years, as measured by options on interest-rate swaps. The so-called payer skew has fallen 4 cents since March 9, while that for three-month protection rose about 3 cents, according to Barclays Plc data. Each 10 cents is equivalent to $100,000.

“The options market does not expect a further violent rise in rates,” Piyush Goyal, a fixed-income strategist in New York at Barclays, said in a March 22 telephone interview. “If the option market believed in a very large back-up in yields similar to what we got in final quarter of 2010 when rates went from 2.5 percent to 3.5 percent, the payer skews would have risen more.”

Mortgages Outperform

Credit-default swaps back that view. The cost of insuring the U.S. government’s debt from losses for five years with the contracts fell to 30.3 basis points last week, the lowest level since 2009 and down from a 2012 high of 51.5 basis points on Jan. 5.

Rather than lagging behind, mortgage securities are outperforming in part on speculation that the Fed may carry out a third round of quantitative easing focused on debt backed by home loans to bolster the housing market.

The option-adjusted spread between mortgage bonds and Treasuries narrowed to 0.29 percentage point on March 22 from 0.44 percentage point at the end of 2011, according to Bank of America Merrill Lynch indexes. The securities have produced a return in excess of Treasuries of 0.45 percentage point this month, the most since December 2010, Barclays index data show.

“At 8.3 percent unemployment, has the Fed achieved what it was trying to?” David Glocke, a bond fund manager at Vanguard Group Inc. in Valley Forge, Pennsylvania, said in a March 21 telephone interview. Vanguard’s $138.1 billion in Treasuries makes it the largest U.S. owner of the debt after the Fed.

“I don’t think Ben Bernanke is going to feel that he’s hit that target yet if things stay where they are,” Glocke said. “More likely than not, there’s probably some additional amount of quantitative easing that’s in the future.”



Before it's here, it's on the Bloomberg Terminal. LEARN MORE