Pimco Says Market Underestimates Fed Rate Path, Recommends TIPS

  • TIPS return 6.6% in first half, versus 5.7% for nominal bonds
  • Gauge of inflation expectations falls to record after Brexit

Pacific Investment Management Co., which manages the world’s biggest active bond fund, says traders are underestimating the potential for the Federal Reserve to raise interest rates following Britain’s decision to leave the European Union.

The bond firm also says it’s a good time to buy Treasury Inflation Protected Securities. It has been recommending TIPS throughout 2016. The securities returned 6.6 percent in the first half, versus 5.7 percent for the broader market, based on Bank of America Corp. data. Financial markets don’t expect a rate increase until the end of 2018, according to a Pimco report Thursday on the company website.

“That to us seems implausible and we think it worth positioning for a faster pace of tightening,” Andrew Balls, the London-based chief investment officer for global fixed income, wrote in the report. “U.S. TIPS are attractively priced and offer valuable protection against the possibility of higher U.S. inflation over the coming years.”

Treasury 10-year note yields fell two basis points to 1.45 percent as of 6:50 a.m. in London, according to Bloomberg Bond Trader data. The price of the 1.625 percent security due in May 2026 rose 6/32, or $1.88 per $1,000 face value, to 101 19/32. Japan’s 10-, two- and five-year yields as well as Taiwan’s 10-year yields slid to record lows.

Abandoning Bets

The Pimco Total Return Fund, the biggest actively managed bond fund with $86.1 billion in assets, has returned 4.3 percent over the past year, lagging behind about 60 percent of its peers, based on data compiled by Bloomberg.

Traders abandoned bets for the Fed to raise rates in 2016 after the U.K. voted last week to leave the EU, raising speculation the decision will curb economic growth in Britain and around the world. 

For more on the Federal Reserve and the outlook for interest rates, click here.

Investors are getting mixed signals on the outlook for inflation.

Crude oil futures contracts surged 26 percent in the April-to-June period, the biggest quarterly gain in seven years.

One gauge of U.S. inflation expectations fell to a record low this week. The five-year, five-year break-even rate, an index used by the central bank help to guide policy, tumbled to 1.31 percent, the lowest level in figures that go back to 1999, based on data compiled by Bloomberg. The number is a projection of the rate consumer prices will increase from 2021 to 2026.

“The world economy is not strong,” said Hajime Nagata, a bond investor in Tokyo at Diam Co., which manages $168 billion. “It’s fair to think the U.S. is going to have a very low level of inflation. I don’t think the Fed is going to move now.”

Nagata said he’s betting on further gains in Treasuries, holding bonds with longer durations than those in the benchmark he uses to gauge performance. Duration is a measure of a portfolio’s sensitivity to changes in yield, and a larger figure indicates a more bullish view.

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