Treasuries Recovery Shows Reflation Trade Failing to Take Hold

The great inflation revival is on hold.

Treasury bears who spent the first four months of 2015 ratcheting up expectations for rising consumer costs have changed their minds.

Weaker-than-forecast data on wholesale prices, retail sales and consumer confidence are diminishing the outlook for a jump in the consumer price index. Success by the Federal Reserve in reviving inflation expectations is seen as necessary for policy makers to raise interest rates.

“On the inflation picture, everyone was hoping the glass was half full, which then would help the Fed move toward tightening policy sooner,” said Sean Simko, who oversees $8 billion at SEI Investments Co. in Oaks, Pennsylvania. “In reality, inflation expectations are pretty static.”

Simko said he recently bought 10-year notes and sold Treasury Inflation-Protected Securities.

Treasuries snapped a three-week slump that mirrored declines in Europe. German bunds tumbled for a fourth straight week, the longest streak since 2012.

Market Prices

Ten-year note yields fell one basis point this week, or 0.0.1 percentage point, to 2.14 percent in New York, according to Bloomberg Bond Trader prices time. The benchmark 2.125 percent security due in May 2025 was at 99 27/32.

Treasuries have held their allure versus major peers on a relative-value basis. The 10-year yield is almost one percentage point higher than the average of the Group of Seven nations, according to data compiled by Bloomberg.

The U.S. 10-year break-even rate, a gauge of the inflation outlook derived from the yield difference between Treasuries and index-linked securities, show expectations for an annual increase of 1.86 percentage points through 2025. They had reached 1.95 percent May 1, up from a more-than four-year low of 1.53 percentage points Jan. 13.

Central bank officials forecast that their preferred measure of inflation, which tracks personal consumption, will reach 2 percent in 2017. The Fed has kept its benchmark, the target for overnight loans between banks, in a range of zero to 0.25 percent since December 2008 to support the economy. It last raised the rate in 2006.

“I’m not ready to take September off the table, but there’s no question the numbers have been soft, and it’s certainly a possibility it’ll be pushed out until December, or maybe 2016,” said Larry Milstein, managing director in New York of government-debt trading at R.W. Pressprich & Co.

The odds of a Fed interest-rate increase in September were to 18 percent, according to CME Group Inc. calculations of fed funds futures prices. The odds for December are 51 percent.

The central bank will release minutes from its April 28-29 meeting on May 20. In its statement, the rate-setting Federal Open Market Committee said it will be appropriate to raise interest rates when it is “reasonably confident that inflation will move back to its 2 percent objective over the medium term.”

The Treasury is scheduled to sell $13 billion of 10-year TIPS on May 21, followed the next day by a Labor Department report which economists forecast will show that year-over-year consumer prices fell last month by the most since 2009.

“I wouldn’t characterize this as a big softening of inflation expectations,” said Michael Pond, head of global inflation-linked research at Barclays Plc, one of 22 primary dealers that trade with the Fed. “We do have an auction to set up for.”

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