Long Bond Rallying Five Times TIPS Gives Fed Room for QE4
As investors sought a refuge from inflation in August amid concern about Federal Reserve efforts to prop up the U.S. economy, David Brownlee was buying the securities most vulnerable to rising consumer prices.
Brownlee, who helps oversee $29 billion at Sentinel Asset Management, bought 30-year Treasuries, proved prescient as the Fed’s third round of monetary stimulus failed to ignite inflation. The government’s longest-maturity bonds gained 6.42 percent, compared with 1.37 percent for Treasury Inflation Protected Securities, since the central bank said Sept. 13 that it would buy $40 billion a month in mortgage bonds.
While TIPS, whose principal rises and falls with the U.S. consumer price index, beat Treasuries that aren’t indexed to inflation in previous episodes of quantitative easing, or QE, this time is different. The bond market expects inflation to remain contained for the next decade, giving Fed Chairman Ben S. Bernanke and President Barack Obama time to boost the economy five years after the start of the worst financial crisis since the Great Depression.
“Inflation is on the backburner until you see a strong economy,” Brownlee, the head of fixed-income at Sentinel Asset Management, said in a Dec. 7 interview from Montpelier, Vermont. “We take the Fed at its word that rates are going to be relatively low.”
Dealers that trade with the Fed expect the central bank to begin buying as much as $45 billion a month in Treasuries at its Dec. 12 meeting and keep benchmark interest rates about zero into 2015, Bloomberg surveys show. The purchases would come on top of the $40 billion per month of mortgage securities announced in September.
The Fed has already pumped $2.3 trillion into the financial system through two rounds of QE without unhinging its inflation as per its preferred measure, the personal consumption expenditures index.
The gauge rose 1.7 percent in October from a year earlier, less than the central bank’s long-run goal of 2 percent, giving policy makers latitude to further debase the currency and U.S. assets. Excluding food and energy costs, it increased 1.6 percent. The broader consumer price index gained 2.2 percent, the Labor Department said Nov. 15.
The difference between 10-year yields on government debt that isn’t linked to CPI and TIPS has narrowed to 2.49 percentage points from 2.64 on Sept. 14. The gap, known as the breakeven inflation rate, represents the bond market’s forecast for the rise in consumer prices for the life of the securities.
Expectations of inflation as measured by the Fed’s five- year five-year forward breakeven rate, which gauges the predicted pace of consumer price increases from 2017 to 2022, fell to 2.73 percent as of Dec. 4, from 2.88 after the start of QE3 three months earlier.
“The money creation we’ve seen over the past few years will eventually at some point down the road be the cause of an inflation problem, but I just don’t see it happening this year, or next year, or the year after,” Gregory Whiteley, who oversees Treasuries at DoubleLine Capital LP in Los Angeles, which manages $50 billion, said in a Dec. 3 telephone interview.
Whiteley held on to 10- and 30-year Treasuries in July as TIPS surged. DoubleLine’s $35.8 billion Total Return Bond Fund gained an annual average of 13.2 percent from its inception in April 2010 through Nov. 28.
“Treasuries 10-years out to 30-years have some prospect for doing well in the next 12 months,” he said.
Yields for 10-year Treasury notes were little changed last week at 1.62 percent. The price of the benchmark 1.625 percent security due November 2022 fell 2/32, or 63 cents per $1,000 face amount, to 100 in New York, according to Bloomberg Bond Trader prices. Thirty-year yields were little changed at 2.81 percent, after reaching a 12-month high of 3.49 percent in March.
The benchmark 10-year yield dropped one basis point, or 0.01 percentage point, to 1.61 percent at 11:06 a.m. in New York.
Brownlee has been buying 30-year Treasuries when yields have been on the higher end of their range since May of between 2.44 percent and 3.17 percent and selling when he expects the yield to rise. The Sentinel Total Return (SATRX) Bond Fund that Brownlee co-manages has gained 10.4 percent this year, better than 83 percent of its peers, Bloomberg data show.
Hedge funds and other large speculators are the most bullish on 30-year bond futures since November 2007, the Washington-based Commodity Futures Trading Commission said Dec. 7. Long positions, or bets on gains, exceeded wagers they would fall by 57,904 contracts on the Chicago Board of Trade.
The U.S. economy added 146,000 jobs in November, beating economists’ forecast for an 86,000 gain. The unemployment rate fell to 7.7 percent as 320,000 people left the workforce. The jobless rate had stayed above 8 percent since February 2009 until it fell to 7.9 percent in September.
Rising employment hasn’t yet fostered higher wages. Average hourly earnings rose 1.7 percent from a year earlier, less than half the four-year high of 3.7 percent in January 2009.
Companies have been unable to raise prices. Bookseller Barnes & Noble (BKS) Inc. cut the cost of its Nook tablet computers and e-books by from 12 percent to 20 percent. McDonald’s Corp. (MCD), which had declining same-store sales in October for the first time in nine years, is focusing advertising on its dollar menu, including its McDouble cheeseburger, to boost revenue.
“The lack of wage growth has kept inflationary pressures limited, and that has allowed the Fed to continue providing its elevated level of accommodation which in turn has spurred the recovery more than we might otherwise have seen,” Ian Lyngen, a government bond strategist at CRT Capital Group LLC in Stamford, Connecticut, said in a Dec. 6 telephone interview.
CRT forecasts 10-year yields will fluctuate between 1.4 percent and 2.5 percent next year.
Investors concerned about faster inflation have history on their side. In the two months following the Fed’s March 2009 Treasury purchase announcement, TIPS returned 0.6 percent, compared with a 5.3 percent loss for U.S. government debt maturing in 10 years or longer, Bank of America indexes show.
For the two months after QE2 was announced, longer-term Treasuries lost 4.9 percent as TIPS fell 3.6 percent.
Consumer prices may rise if the U.S. currency declines. The Dollar Index (DXY), which IntercontinentalExchange Inc. uses to track the greenback against currencies of six U.S. trading partners, declined 6.1 percent from July 24 through Sept. 14 to 78.85, though it has since recovered to 80.45. A cheaper dollar makes commodity imports more expensive.
The Standard & Poor’s GSCI Total Return Index of commodities rose about 20 percent in the three months leading up to the Fed’s QE3 announcement. It’s since fallen 9.1 percent.
“Some of the weakness we’re seeing in the dollar begins to lay the groundwork for higher prices in the commodity world, and that’s going to flow through into inflation rates,” Mitchell Stapley, the Grand Rapids, Michigan-based chief fixed-income officer for Fifth Third Asset Management, said in a telephone interview Dec. 5. The firm oversees $15 billion in assets.
Until inflation picks up, Bernanke has room to provide more stimulus for job growth as Congress debates how to avert $607 billion in spending cuts and tax increases that the Congressional Budget Office says might tilt the economy into recession next year.
Obama and House Speaker John Boehner, an Ohio Republican, remain deadlocked on how to avert the so-called fiscal cliff.
“We’re going to do what we can to support ongoing recovery in growth and jobs and create the demand for output, the demand for firms’ products that will remove that uncertainty about the future sustainability of the recovery,” Bernanke said in a Nov. 20 speech at the Economic Club of New York. “We want to be sure that the recovery is established before we begin to normalize policy.”
Besides the two rounds of QE and $40 billion a month in mortgage bond purchases that started Sept. 14. The central bank has kept its target for overnight bank lending at a record low of zero to 0.25 percentage point since December 2008 and indicated it will stay there into 2015.
All 21 primary dealers forecast the central bank will announce a fourth program of Treasury purchases at its Dec. 12 meeting, according to a Bloomberg News survey published Dec. 3. Seventeen of the firms project $45 billion of purchases, with the average forecast at $42.2 billion.
The new stimulus would come as inflation expectations fall. The five-year, five-year forward rate fell to 2.73 percent by Dec. 5, from 2.88 percent at the start of QE3. It jumped 1.12 percentage points to 3.27 percent on June 2, 2009, 10 weeks after the Fed first said it would buy Treasuries, and rose 1.10 percentage points to 3.28 percent in December 2010, six weeks after the announcement of the $600 billion QE2.
“It’s worked out well from the Fed’s perspective in terms of how actual inflation has played out and how they’ve been able to manage inflation expectations to this point,” Sean Hughes, a money manager in Hartford at Conning & Co., which manages $91 billion of assets, mostly for insurers, said in a Dec. 5 telephone interview. “The concern is a longer-term one.”
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