Treasuries Gain as Tepid Inflation Bolsters Longer-Dated Bonds

  • U.S. debt recoups losses sustained after Fed rate increase
  • BlackRock's Rick Rieder says Fed rate shift was right move

Treasuries climbed, with long-term debt recouping losses sustained after the Federal Reserve raised interest rates Wednesday, driven by expectations for low inflation and a slow pace of future increases.

Fed Chair Janet Yellen increased the benchmark U.S. interest rate and said policy makers were confident inflation would accelerate toward their 2 percent target over the medium term. Traders aren’t so certain, as plunging commodities have kept consumer prices low.

The gap between yields on two-year and 30-year debt fell to the narrowest since April as oil continued to drop Thursday and the Bloomberg Commodity Index reached a 16-year low. Bond bulls were also cheered by the Fed’s commitment to maintain its holdings of Treasuries and mortgage bonds until rate normalization is "well under way."

"The market’s reacting more to inflation and what’s going on in oil today," said George Goncalves, head of interest-rate strategy at Nomura Holdings Inc. in New York, one of 22 primary dealers that trade with the Fed. Next year, "it’s going to be about this big balance sheet that’s starting to look like they’re going to keep for longer."

The benchmark 10-year note yield dropped seven basis points, or 0.07 percentage point, to 2.22 percent at 5 p.m. New York time, after rising by three basis points on Wednesday, according to Bloomberg Bond Trader data. The 2.25 percent note maturing in November 2025 climbed 5/8, or $6.25 per $1,000 face amount, to trade at 100 7/32.

Slow Pace

The U.S. sold $16 billion of five-year Treasury Inflation Protected Securities at a yield of 0.472 percent on Thursday, the highest yield since 2010. Buyers bid for 2.38 times the amount available, slightly below the average for the past five years.

The specter of higher interest rates hasn’t led to Treasury market losses in 2015. U.S. government securities have returned 0.8 percent this year through Wednesday, with the gain slowing from 6.2 percent in 2014, according to Bloomberg World Bond Indexes.

Traders are betting that the Fed will move slowly, which would help limit losses in long-term Treasuries. The next interest-rate increase isn’t reflected in futures prices until the third quarter of 2016, according to data compiled by Bloomberg. Futures traders are betting the Fed will raise interest rates twice next year, data show.

Different Expectations

Yet most Fed officials’ estimates for 2016 interest rates are above that. The median estimate from Federal Open Market Committee officials is for the central bank to raise interest rates to 1.375 percent in 2016, unchanged from their previous meeting.

"There are four hikes priced into the median estimate" from Fed officials, said Thomas Simons, a money-market economist in New York at Jefferies Group LLC, a primary dealer. "That’s why we’ve seen a lot of back and forth in the market over the last 24 hours."

Bill Gross, the former manager of the world’s biggest bond fund who’s now at Janus Capital Group Inc., said low inflation will keep the Fed from raising rates more than one more time. 

“Two and wait I think is probably what we’re going to see,” Gross, who is based in Newport Beach, said in an interview Wednesday in the U.S. “She’s going to be waiting on inflation hitting 2 percent for a long, long time.”

The break-even rate, which measures the difference between yields on 10-year inflation-indexed securities and nominal equivalents, showed traders are pricing in annual price growth of 1.50 percent over the next decade.

Smooth Running

The Fed increase will help financial markets function more smoothly, said Rick Rieder, chief investment officer of fundamental fixed income at BlackRock Inc., the world’s largest money manager with $4.5 trillion in assets.

“The Fed has made the right move for the economy and markets,” Rieder, who’s based in New York, wrote in a report. “Both the economy and markets benefit from greater certainty and clarity over the path of interest rates, and uncertainty over that policy path in the past year has generated a considerable amount of market turmoil.” 

Gross says Yellen isn’t giving enough emphasis to Japan, commodity prices and European Central Bank policy, which are all helping keep inflation in check. Japan and Europe are both buying bonds in their regions to try to stave off deflation.

“The Fed basically is living in an old age, as opposed to a new age: a new age that’s reflective of high leverage, it’s reflective of globalization, reflective of factors in terms of demographics that are pushing down inflation,” Gross said.

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