Pimco's Inflation Call Is Paying Off as TIPS Rally to Outperform

  • Bonds linked to consumer-price gains return 0.8% in past month
  • Gauge of inflation expectations rises to highest in two months

Pacific Investment Management Co.’s forecast for quickening inflation is starting to pay off in the bond market.

Treasury Inflation Protected Securities have returned 0.8 percent in the past month, while conventional Treasuries stagnated, based on Bank of America Merrill Lynch indexes. Inflation bonds are reviving after they lagged behind the broader market in each of the past three years.

Pimco has been warning all year that costs are poised to increase. “We expect inflation to rise modestly,” Mihir P. Worah, one of the two managers for the $10.7 billion Pimco Real Return Fund, said in a video on the company’s website last week. Worah, who is based in Newport Beach, California, recommended TIPS on Bloomberg Television in January.

The outlook for consumer prices will guide Fed policy makers, who indicated in December they’d raise interest rates four times in 2016. They stood pat in January, saying inflation is expected to stay low in part because of falling energy prices. New York Fed Bank William Dudley said this week that while he expects inflation to reach the central bank’s 2 percent target over time, he’s less sure now. “I am somewhat less confident,” he said.

Benchmark 10-year note yields were little changed at 1.84 percent as of 10:05 a.m. New York time, according to Bloomberg Bond Trader data. The price of the 1.625 percent security due in February 2026 was 97 31/32.

The 10-year break-even rate, which is derived from the difference in yield between conventional Treasuries and inflation-linked debt, climbed for a 10th day, rising as high as 1.55 percent, the most on an intraday basis since Jan. 7. The gauge, which shows what traders expect inflation to average during the period, dropped to 1.12 percent last month, the least since the U.S. was in a recession in 2009.

The probability the central bank will increase rates this year has risen to about 67 percent from as low as 11 percent in February, according to data compiled by Bloomberg based on fed fund futures.

A flight to quality that sent investors rushing to conventional Treasuries earlier this year is easing, and the focus is returning to the economy, where the latest data are showing improvement from manufacturing to employment. 

Inflation Outlook

U.S. employers hired 195,000 workers in February, after adding 151,000 in January, based on a Bloomberg survey of economists before the government’s monthly employment report on Friday.

The Fed’s preferred inflation gauge climbed to 1.3 percent in January, the highest level since October 2014, government figures last week showed. It has been below the target since 2012. 

QuickTake The Fed Lifts Off

Consumer prices probably aren’t about to take off, said Hajime Nagata, a bond investor in Tokyo for Diam Co., which manages $151.9 billion. “Even though inflation expectations aren’t as low as in mid-February, inflation will be less than 2 percent,” he said. He’s betting a rally in nominal Treasuries has further to go in 2016, he said.

At Pimco, the Real Return Fund has gained 1.7 percent in 2016, lagging behind the majority of its competitors, based on data compiled by Bloomberg. It has returned 2.3 percent annually on average over the past five years, beating 79 percent of its peers.

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