Wall Street Can’t Stop Stripping as Inflation Deemed Dead

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U.S. Inflation
Job seekers fill out paperwork during a Virgin Hotels job fair in Chicago, Illinois, U.S., on Nov. 5, 2014. Inflationary pressures will rise as unemployment drops and the economy gains more momentum, prompting the Fed to lift rates, said Gerard Fitzpatrick, the global CIO of fixed income at Russell Investment. Photographer: Daniel Acker/Bloomberg

An obscure corner of the $12.4 trillion market for U.S. government debt is providing one of the clearest signs yet that bond investors are writing off the threat of inflation for years, if not decades, to come.

Demand for Strips, created when Wall Street banks separate the interest payments from the principal of U.S. debt and sell each at a discount, has boosted the amount outstanding to an average $211 billion this year, the most since 1999, data from the Treasury Department show. The securities, the most vulnerable to inflation of all U.S. government bonds, posted the biggest returns this year by rallying almost 50 percent.

While forecasters say the world’s largest economy will grow at the fastest pace in a decade next year and expose the securities to the deepest potential declines, debt investors are signaling their skepticism as commodities plunge and slowdowns in Europe and Asia threaten the U.S. recovery. Last week, the bond market’s outlook for inflation over the next three decades fell below 1.9 percent annually, the lowest in three years.

“The marketplace feels pretty comfortable that inflation is going to be contained,” Tom Girard, the head of fixed-income investments at NYL Investors, which oversees $200 billion and owns Strips, said by telephone on Dec. 11. There are still “some headwinds that the economy is facing.”

Investors’ expectations for consumer-price increases are diminishing as the Federal Reserve debates how soon to raise its benchmark interest rate, which has been held close to zero since 2008 to support demand in the economy.

Bond Returns

The central bank’s policy makers will meet over two days starting Dec. 16 and discuss their pledge to keep rates low for a “considerable time.”

The Fed’s preferred measure of inflation has also fallen short of its 2 percent goal for 30 consecutive months, even as the central bank inundated the U.S. economy with almost $4 trillion of cheap cash since the financial crisis with its bond-buying program known as quantitative easing.

The lack of price pressures has caused bond investors to pour into Strips, short for separate trading of registered interest and principal of securities. That’s boosted the average amount outstanding by about 20 percent since 2009.

The longest-dated principal portions have returned 47.2 percent this year, index data compiled by Bank of America Corp. show. Only twice since 1997 have they posted bigger annual gains. The advance is also more than quadruple the return for the Standard & Poor’s 500 Index, which has climbed 10.5 percent.

Diminished Expectations

Because Strips are sold at a discount, the longest-dated securities offer the highest yields among U.S. government bonds.

For example, those due May 2044 traded at 43.1 cents on the dollar last week. The buyer, who doesn’t receive interest payments, would receive full face value at the end of 30 years for an annual return of 2.86 percent. That compares with a yield of 2.74 percent for interest-bearing 30-year U.S. bonds.

Their outperformance this year shows bond investors still aren’t sold on the notion the U.S. economy is on the cusp of creating the kind of wage growth that pushes up prices, even as employers add jobs at the fastest pace since 1999.

While average hourly earnings rose 0.4 percent in November, the most since June of last year, in five of the prior eight months they were flat or rose just 0.1 percent.

On an annual basis, growth in hourly wages in the past five years has been the weakest over the course of any expansion since at least the 1960s, data compiled by Bloomberg show.

Risk-Reward

In the bond market, that’s being reflected in falling expectations for inflation.

Based on yields, the outlook for consumer-price increases over the next five years has fallen almost a percentage point since its high in June to a four-year low of 1.13 percent. Inflation expectations over 30 years fell below 2 percent on a closing basis last month for the first time in three years.

“Until wages pick up, it’s going to be harder” for inflation to accelerate, Bill Irving, a money manager at Fidelity Investments, which oversees $35 billion in fixed income, said in a Dec. 10 telephone interview from Merrimack, New Hampshire. “Demand will remain strong for Strips.”

Buying the securities now isn’t worth the risk, said Gerard Fitzpatrick, the global chief investment officer of fixed income at Russell Investments, which oversees $275 billion.

Inflationary pressures will rise as unemployment drops and the economy gains more momentum, prompting the Fed to lift rates, he said. The U.S. economy will expand 3 percent next year, which would be the most since 2005, based on the latest Bloomberg survey of economists.

Exposed Buyers

“The best returns are behind us,” he said by telephone on Dec. 10 from Seattle.

Any selloff would hurt Strips, which are primarily created from 30-year bonds, the most. The securities due in May 2044, which yielded 2.86 percent last week, would lose about 21 percent if yields rose as much as forecasters foresee for long-dated debt by the end of 2015, data compiled by Bloomberg show.

That’s more than the losses that comparable 30-year bonds would suffer and about four times the 5.2 percent decline benchmark 10-year notes would incur.

The plunge in commodities has deepened concern a global slowdown will ensnare the U.S. economy and weigh on prices. Raw materials have dropped 20 percent since their peak in April, while the U.S. benchmark price of oil has slumped about 45 percent in the past six months to less than $60 a barrel for the first time since July 2009.

Oil fell to $55.91 a barrel as of 2:30 p.m. in New York.

‘Downward Pressure’

The swoon comes after the International Monetary Fund cut its 2015 world growth outlook in October to 3.8 percent from a July forecast of 4 percent and pointed to the increasing risk of deflation in Europe. In China, the world’s second-largest economy is poised to expand the least since 1990.

“The slump in oil prices is adding to downward pressure on inflation globally,” Michael Gapen, the chief U.S. economist at Barclays Plc, wrote in a Dec. 12 report. That strengthens the case for central banks to err on the side of caution when it comes to monetary policy, he wrote.

The London-based bank said inflation worldwide will slow to 2.7 percent next year from 2.9 percent in 2014.

With economists cutting their 2015 estimate for U.S. inflation to 1.5 percent from a high of 2.2 percent in August, there’s still reason to be bullish on Strips. Adjusted for next year’s projected increase in consumer prices, the principal portion offers a yield of about 1.4 percent, equal to or higher than regular bonds of similar maturity in Germany and Japan.

“Longer-term Strips will continue to see demand,” Andrew Schulman, a trader at ED&F Man Capital, said by telephone on Dec. 9 from New York. “We’ve got a duration starved world and U.S. rates are higher than all other large economies.”

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