Deflation Dismissed by Bond Measure Amid QE3 AnticipationDaniel Kruger
For all the handwringing over the slowdown in the U.S. economy, the bond market shows there’s less risk of deflation now than before the Federal Reserve’s first two rounds of large-scale debt purchases.
The expectation that consumer prices will rise, measured by the five-year, five-year forward breakeven rate, means that Fed Chairman Ben S. Bernanke has persuaded traders the U.S. will avoid the chronic deflation that has slowed Japan’s economy since 1995. It also complicates the central bank’s decision about starting more quantitative easing to boost an economy that grew at the slowest pace in a year during the second quarter. Commodity prices surged during QE1 and QE2 in 2008 and 2010.
“Higher inflation results in a tax on consumers and slows the economy down,” Michael Materasso, a senior portfolio manager and co-chairman of the fixed-income policy committee at Franklin Templeton Investments, which oversees $320 billion of bonds, said in a July 24 interview at Bloomberg headquarters in New York. “If you end up with a spike in commodity prices, have you done more harm than good?”
The Fed’s favored bond-market gauge of inflation expectations ended last week at 2.39 percent, above the 2 percent levels in 2008 and 2010 that led the central bank to inject $2.3 trillion into the economy by purchasing Treasuries and mortgage-related bonds, the policy known as quantitative easing. The five-year, five-year measure shows how much traders anticipate consumer prices will rise during a period of five years starting in 2017.
The Standard & Poor’s GSCI Total Return Index of 24 raw materials rose as much as 85 percent during the past two easings, pushing the consumer price index to 3.9 percent in September 2009, higher than its long-term average of 2.5 percent since 1992.
Measures that track where bond traders see inflation in the future are key since January when the Fed adopted a 2 percent target for the personal consumption expenditures index. The gauge, excluding food and energy, rose 1.8 percent in May from a year earlier, increasing from as low as 0.9 percent at the end of 2010. It has averaged 1.9 percent since the 1990s.
While the Fed can ignore its target, traders’ outlook for consumer prices “could be a sticking point for more QE,” Chicago-based Bianco Research LLC said in a report to clients on July 27. “These measures show too much inflation for the time being.”
Treasuries fell last week as investors saw less need to hold the safest assets after European Central Bank President Mario Draghi said policy makers would do whatever it takes to preserve the euro, sending the currency and stocks higher.
Treasury 10-year yields rose nine basis points, or 0.09 percentage point, to 1.55 percent, according to Bloomberg Bond Trader prices. The benchmark 1.75 percent note due May 2022 fell 27/32, or $8.44 per $1,000 face amount, to 101 26/32.
The yield, which reached an all-time low of 1.3790 percent on July 25, fell four basis points to 1.51 percent as of 12:38 p.m. in New York.
Bonds declined last week even though the Commerce Department in Washington said on July 27 that gross domestic product rose at a 1.5 percent annual rate last quarter after a revised 2 percent gain in the three months ended March 31. The rate, which was the slowest since the third quarter of 2011, compared with the 1.4 percent median estimate of 82 economists surveyed by Bloomberg.
The government will say Aug. 3 the unemployment rate held above 8 percent in July for the 42nd-straight month, the median estimate of more than 65 economists surveyed by Bloomberg shows.
“You don’t need to pump up inflation, but what you’re looking at is them wanting to support growth.” Scott Sherman, an interest-rate strategist at Credit Suisse Group AG in New York, said in a July 25 telephone interview.
The firm, one of the 21 primary dealers of government securities that trade with the Fed, forecasts a 30 percent probability of the Fed announcing QE3 at its two-day meeting ending Aug. 1, with the odds rising to 60 percent at the Sept. 13 gathering if the economy continues to weaken.
Investors have been willing to buy bonds that pay less than the rate of inflation because of the safety they offer as Europe’s debt crisis intensifies and the global economy slows. Spain and Cyprus joined Greece, Portugal and Ireland in seeking bailouts from the European Union.
The average yield on bonds issued by the Group of Seven nations dropped to 1.125 percent on July 27 from 3 percent in 2007, Bank of America Merrill Lynch index data show. Germany’s two-year note yield fell below zero for the first time on June 1, while Switzerland’s has been negative since April 24, meaning investors are paying for the right to lend those nations money.
Central banks are digging deeper into their tool kits in search of innovative ways to bolster their economies.
The People’s Bank of China joined the ECB on July 5 in cutting its benchmark rate, while the Bank of England raised the size of its asset purchases. Two weeks earlier, the Fed expanded a program lengthening the maturity of bonds it holds in a program traders call Operation Twist.
With U.S. yields at record lows, some investors doubt more Fed stimulus will work, according to James Sarni, a senior managing partner at Los Angeles-based Payden & Rygel, which manages $60 billion.
“Buying more mortgages or buying more Treasuries or agencies, I just don’t think it’s going to do much good,” Sarni said in a July 25 telephone interview. “The Fed cannot unilaterally solve all the world’s problems.”
The expiration of tax cuts started by President George W. Bush and spending reductions to take effect at the start of 2013 would pull $607 billion from the economy, according to the Congressional Budget Office. If Congress doesn’t act, those events would “pose a significant threat to the recovery,” Bernanke told lawmakers in testimony on June 7.
The Fed’s QE program started with a November 2008 commitment to buy $500 billion of mortgage securities and $100 billion of debentures of Fannie Mae and Freddie Mac. Policy makers raised the purchase targets in March 2009 to $1.25 trillion of mortgage bonds, $200 billion of agency debt and added $300 billion of Treasuries. In November 2010, the Fed announced it would acquire $600 billion of Treasuries.
The programs created about $2.3 trillion dollars, sparking criticism by Chinese Premier Wen Jiabao, who said in March 2011 that QE2 boosted prices for commodities traded in the U.S. currency. Representative Stephen Fincher, a Republican from Tennessee, said this month during Bernanke’s testimony to Congress that “there is so much money out there” that “inflation is going to be a huge problem.”
Crude oil reached $114.83 a barrel in May 2011, from $70.76 in August 2010. It was at $90.01 today. Rotterdam-based Unilever, the world’s second-biggest consumer-goods maker, sees commodity cost inflation in 2012 to be “slightly higher” than a mid-single-digit increase, unchanged from its forecast in April, Chief Financial Officer Jean-Marc Huet said on a July 26 conference call with reporters.
Bernanke has studied policy errors in the Great Depression and during Japan’s rolling recessions of the 1990s. He said in 2000 that the Bank of Japan should pursue faster inflation to curb the risk of deflation, adding earlier this year that the Fed’s stimulus programs have averted that fate in the U.S.
“The very critical difference between the Japanese situation 15 years ago and the U.S. situation today is that Japan was in deflation,” he said in response to a question at a press conference after policy makers met April 25, the last time he addressed the issue. “We are not in deflation, we have an inflation rate that’s close to our objective.”
Treasury Inflation-Protected Securities, which offer investors a lower annual rate of interest than Treasuries in exchange for an increase in the face value of the debt equal to the rise of the consumer price index, have returned 1.19 percent this month and 5.42 percent for the year. That compares with returns of 0.69 percent in June and 2.36 percent in 2012 for U.S. debt that isn’t linked to price measures, Bank of America Merrill Lynch indexes show.
The five-year, five-year forward breakeven rate, which the Fed uses to help set policy, has ranged this year from 2.37 percent on March 5 to 2.78 percent on March 19. The 0.39 percentage point drop from its high this year contrasts with the 1.59 percentage point plunge to 2.02 percent between October and November 2008, and the 0.98 percentage point decline to 2.18 percent between April and August 2010.
A further decline “is probably what the Fed will need to see before they pull the trigger on further easing,” Robert Robis, head of fixed-income macro strategies in Atlanta at ING Investment Management, which manages about $160 billion, said in a July 25 telephone interview.
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