Bond Investors Detect a Whiff of Inflation

Federal Reserve Chairman Ben Bernanke's $600 billion plan to slay deflation, and perhaps spark some modest inflation, has a chance of working if the market for bond options is any indication. The question is whether his grand plan will engineer a recovery as well.

As the central bank starts a second round of Treasury purchases through its quantitative easing policy, investors are paying eight times more than they did in April for options on interest rate swaps that protect against rising yields, relative to options on swaps that bet on yields falling, according to Barclays (BCS) data. The difference between these options, which in traders' parlance is called the payer skew, has widened by 23 basis points since early April. When a bond's price declines, its yield goes up. Bond yields often go up when investors expect inflation to accelerate. Conversely, when investors bid up bond prices, yields drop, a sign that more inflation is not expected.

In a quarterly Bloomberg Global Poll of 1,030 investors, analysts, and traders, 56 percent said the Bernanke plan won't boost growth. Half of them, however, did say quantitative easing will help avoid deflation. Defanging deflation may be more important to Bernanke, since a decline in prices makes consumers and businesses less willing to invest. Moderate inflation makes it easier for companies to make higher profits, which encourages them to spend more. A little inflation also encourages consumers: Everyone likes to see the value of their home rise.

Bernanke and other members of the Federal Open Market Committee, who have kept the central bank's target for overnight interest rates between banks near zero since 2008, "are happy to see that inflation expectations have moved up," says Stuart Spodek, a managing director at New York-based BlackRock (BLK), the world's biggest money manager.

Pushing inflation seems to contradict the Fed's dual goals of keeping rates low enough to spur growth while still promoting stable prices. The idea is to brew up enough inflation to help the economy while still keeping inflation-adjusted rates affordable. "Bernanke will be successful," says Fabrizio Fiorini, who manages $8 billion as head of fixed income at Aletti Gestielle SGR in Milan. "A rise in yields will create a virtuous circle that will be helpful for housing, consumer confidence, and probably employment."

Others disagree. On Nov. 15, 23 economists and former Republican policymakers asked Bernanke to drop his strategy. "The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed's objective of promoting employment," said the group's letter. Its publication helped spark a Treasury selloff. Yields on 10-year Treasuries recently surged to 2.85 percent.

While the markets anticipate prices will pick up in a year, there's little inflation now. On Nov. 17 the government said the cost of goods and services excluding food and energy rose 0.6 percent in October from a year earlier—the smallest year-over-year gain since 1961.

The bottom line: Despite few signs of inflation now, bond options are anticipating a rise in prices. That would lower the risk of deflation settling in.

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