Deflation Warning Sounds as 2-Year Break-Even Rates Go Negative

Even with the Federal Reserve reminding investors that policy makers remain on course to raise interest rates next year, one corner of the bond market is warning of the risk of deflation.

The difference in yields between Treasury two-year notes and comparable maturity inflation-indexed securities turned negative yesterday for the first time since the aftermath of the global financial crisis in 2009. The measure, known as the break-even rate, is generally seen as reflecting investors’ expectations for inflation over the life of the securities.

Fed Chair Janet Yellen downplayed the notion at the press conference after the conclusion of yesterday’s two-day policy meeting. Falling break-even rates may represent a decline in the inflation premium risk or the range of inflation outcomes investors are taking into consideration, she said. One of the justifications for the Fed to raise rates for the first time since 2006 is to keep consumer price increases from getting out of control.

“The global landscape is a world with reduced growth expectations and reduced inflation expectations, and we’re not immune to that,” said Michael Lorizio, senior trader at Manulife Asset Management in Boston.

The drop in the break-even rate followed a Labor Department report yesterday that showed consumer prices dropped 0.3 percent in November, the most in almost six years, on tumbling energy prices. Principal and interest payments on Treasury Inflation Protected Securities are indexed to changes in the consumer price index, so a lower than forecast CPI diminishes the value of projected future payments from TIPS.

The break-even rate dropped to negative 0.035 percent yesterday. The difference was 0.024 percent today.

The negative break-even rate represents “an uncertainty premium that maybe oil could fall to $40 a barrel,” said Donald Ellenberger, who oversees about $10 billion as head of multi-sector strategies at Federated Investors in Pittsburgh. “The shortest-term TIPS are very influenced by the direction of the consumer price index. It’s telling you inflation on the short-end could turn negative.”

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