Who’s Afraid of Fed Raising Rates? Not These Bond Buyers

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U.S. Federal Reserve Chair Janet Yellen
Even as the U.S. economy shows signs of gaining momentum, buyers are pouring into long bonds because the collapse of inflation expectations suggests long-term growth will moderate as U.S. Federal Reserve Chair Janet Yellen lifts borrowing costs from close to zero. Photographer: Andrew Harrer/Bloomberg

For all the talk that U.S. Treasuries will tumble once the Federal Reserve starts to raise interest rates, investors in the longest-dated debt securities are finding little cause for concern.

Government bonds due in 30 years, the most vulnerable to losses when growth picks up and inflation accelerates, have returned more than 20 percent this year versus 2.9 percent for five-year Treasuries. That’s reduced the yield premium that investors demand to hold the 30-year securities to 1.44 percentage points, close to the lowest since 2009.

Even as the U.S. economy shows signs of gaining momentum, buyers are pouring into long bonds because the collapse of inflation expectations suggests long-term growth will moderate as Fed Chair Janet Yellen lifts borrowing costs from close to zero. The five-year inflation outlook starting in 2019 has fallen a half-percentage point this year and reached a three-year low of 2.14 percent last month, based on a bond metric known as the five-year, five-year forward break-even rate.

“The tenet is still in place for the long end to do better,” Wilmer Stith, a Baltimore-based fund manager at Wilmington Trust, which oversees $82 billion, said by telephone on Nov. 7. “The drumbeat of Fed returning to a normalization of monetary policy is growing louder. Inflation is very well maintained below” the Fed’s own 2 percent target.

Stagnant Wages

Stith said the firm is buying 30-year Treasuries as part of a “barbell” strategy that includes adding one-year debt and selling notes due in 3 years to 5 years, which he said stand to bear the brunt of losses as rates increase.

Longer-term Treasuries rallied after last week’s employment report bolstered the view that stagnant wage growth is keeping price pressures in check as the world’s largest economy adds the most jobs in 15 years. Average hourly earnings rose 0.1 percent from the prior month, half the increase economists projected, the Labor Department report showed. It was the fifth time this year that wages either increased 0.1 percent or were unchanged.

Yields on 30-year bonds ended at 3.03 percent last week, about 0.1 percentage point from the lowest closing level in a year and almost a full percentage point below where they were at the start of 2014. At that time, almost everyone predicted yields on Treasuries of all maturities would increase as the Fed’s bond buying program bolstered a rebound in the U.S. economy, spurred faster inflation and put the central bank on track to end its near-zero rate policy.

‘Inflation Genie’

The yield was at 3.07 percent as of 11:55 a.m. in New York.

While the strongest six months of U.S. economic growth in a decade has futures traders pricing in the prospect the Fed will raise rates within a year, lackluster wage gains, weaker growth abroad and slumping energy prices caused investors to trim their expectations for how much consumer prices can rise.

With the Fed’s preferred gauge of inflation falling short of its target for 29 straight months, bond yields now imply consumer prices in the five-year span starting November 2019 will rise an average of 2.17 percent per year.

In the five years before the crisis, living costs measured by the U.S. consumer price index rose almost 3 percent on average. The bond market’s inflation outlook in the next three decades is even lower, falling to 2.1 percent annually. The quarter percentage-point drop this year is the most since 2011.

“I’m not looking for the inflation genie to get out of the bottle,” Jack McIntyre, a Philadelphia-based money manager at Brandywine Global Investment Management LLC, which oversees $45 billion, said by telephone on Nov. 7.

ETF Exodus

Investors have responded by seeking out longer-term Treasuries to reap the biggest inflation-adjusted returns and shifting way from the shortest-term notes as they anticipate the end of the Fed’s six-year-long policy of near-zero rates.

Last week alone, the iShares 20+ Year Treasury Bond ETF, the $5.2 billion exchange-traded fund, had more than a half-billion dollars of net inflows, data compiled by Bloomberg show. That’s the most for a week since June and adds to the $507 million the ETF accumulated last month.

The $10.4 billion iShares 1-3 Year Treasury Bond ETF has lost more than 10 percent of its assets after 13 straight days of withdrawals through last week, the longest stretch since the fund began in 2002, the data show.

Another reason longer-term Treasuries remain in demand is because of deepening concern that growth is unlikely to match previous expansions, said Gregory Whiteley, a money manager at DoubleLine Capital LP, which oversees $56 billion.

Bond Bull

Since the recession ended in 2009, the economy has expanded at an annual rate of 1.8 percent on average. In the prior three expansions, growth averaged more than 3 percent.

“There’s no compelling reason to believe in the prospect of higher yields,” he said by telephone from Los Angeles on Nov. 6. Whiteley, who bought longer-dated Treasuries as recently as last month, said he maintains an “overweight” position.

Martin Hegarty, the head of inflation bond portfolios at BlackRock Inc., says there’s plenty of evidence the economy is on the cusp of generating levels of growth and inflation that have been absent during the five-year-long expansion.

The jobless rate declined to 5.8 percent in October, the lowest since July 2008. The lowest costs at the gas pump in four years may also help spur buying power and household purchases heading into the U.S. holiday-shopping season after consumer confidence jumped to a seven-year high in October.

“The unemployment rate is coming down and spare capacity is being eroded,” Hegarty at BlackRock, which oversees more than $4 trillion, said by telephone Nov. 5.

Win-Win

He expects that core consumer prices, which exclude food and energy costs, may rise in a range from 2 percent to 2.25 percent in the first quarter of 2015. The last year that core inflation averaged more than 2 percent was 2006.

Fed officials also said in last month’s policy statement that survey-based measures for longer-term inflation have remained stable and suggested that market-based indicators were being pushed down temporarily by energy prices. Expectations for inflation over the next decade average 2.2 percent, the Philadelphia Fed’s survey of forecasters shows.

For Vince Foster, a money manager and interest-rate strategist at Southern Bancorp, which has $1.2 billion in assets, the Fed’s resolve to raise rates ultimately benefits longer-term bonds the most by stamping out any risk that prices will accelerate beyond the central bank’s ability to control.

The rally in 30-year bonds this year has already reduced the extra yield investors demand versus two-year notes to 2.53 percentage points, the least since 2012.

Tighter Fed policy translates “into a flatter yield curve,” he said by telephone from Little Rock, Arkansas, on Nov. 6. That means “I am much more willing to hold duration if I don’t have to worry as much about a spike in inflation risk.”

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