Bond Market’s Fading Inflation View Seen Undercutting Job Gains

The punch bowl is still on the table for Treasury bond investors if inflation expectations are a guide.

Bond bears looking to link another month of strong job gains next week with the Federal Reserve’s desire to reduce monetary stimulus -- or remove the punch bowl just as the party gets going -- may be disappointed. Declining inflation measures counter that view, suggesting the central bank won’t raise interest rates until at least late 2015 and will proceed at a cautious pace.

“We don’t have enough momentum in the economy to maintain sustainable inflation,” said George Goncalves, head of interest-rate strategy at Nomura Holdings Inc., one of 22 primary dealers that trade directly with the Fed. “The market is viewing this as: be cautious, be gradual, don’t rush into this.”

Goncalves said he forecasts the Fed will raise rates in September and that 10-year note yields will trade between 1.95 percent and 2.35 percent in coming months.

Ten-year yields fell nine basis points this week, or 0.09 percentage point, to 2.12 percent in New York, according to Bloomberg Bond Trader prices. The benchmark 2.125 percent securities maturing in May 2025 added 25/32, or $7.81 per $1,000 face amount, to 100.

Bond Returns

The Bloomberg U.S. Treasury Bond Index has returned 0.6 percent this year. The measure of all maturities greater than 12 months lost 0.5 percent this month as of May 28.

Inflation expectations had moved up last week as a measure of core prices exceeded forecasts and Fed Chair Janet Yellen said she still expects to raise rates this year if the economy meets her forecasts. Since then, commodity prices have declined and the inflation outlook has been walked back.

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, fell to 1.81 percentage points on May 28, after reaching 1.90 on May 22.

“The move of least resistance is lower in yield,” said Edward Acton, a U.S. government bond strategist at RBS Securities Inc. in Stamford, Connecticut, one of 22 primary dealers that trade with the Fed. “The market wants to be bullish here.”

The economy may have added 225,000 jobs in May, according to a Bloomberg survey of economists before the June 5 report. The unemployment rate is forecast to remain at a seven-year low 5.4 percent.

The report will provide clue about whether the economy will rebound as gross domestic product declined at a 0.7 percent annualized rate in the first quarter, revised from a previously reported 0.2 percent gain.

The Fed makes its next announcement about the path of monetary policy on June 17.

Traders assign a 24 percent chance that the Fed will raise interest rates in September, according to data from CME Group. The chance that the central bank will raise rates by the end of this year is 57 percent.

The U.S. central bank has held its target for the federal funds rate at virtually zero since December 2008 to bolster economic growth.

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