Bond Market Ramps Up Inflation View While Fed Seen Staying Put

  • Traders see zero chance of rate rise in April, 64% by year-end
  • BlackRock says central bank concerned with `external factors'

Scope for Fed Summer Hike Widens

Bond traders are signaling that even inflation expectations at 2016 highs won’t be enough to push the Federal Reserve to raise interest rates this week.

Futures show the central bank will hold its benchmark unchanged when it meets Tuesday and Wednesday as policy makers incorporate international events into monetary-policy decisions. The meeting will give policy makers a chance to either ratify or scale back their stance from their last review in March, when they changed their outlook for rate increases this year to two from four. Officials cited weaker global growth while saying they’re monitoring inflation.

A bond-market gauge of inflation expectations rose to the highest level in nine months after a three-week run of gains in oil. The difference between yields on five-year notes and similar-maturity Treasury Inflation Protected Securities, a gauge of trader expectations for consumer prices over the life of the debt, widened to as much as 1.58 percentage points Monday. It’s the highest since July, though short of the central bank’s 2 percent target. Inflation expectations have risen as crude oil has rallied 64 percent from a 12-year low set in February.

"We took inflation expectations too low as we flinched against possible declines in oil,” said Jim Vogel, head of interest-rate strategy at FTN Financial in Memphis, Tennessee. "Now we have to take inflation expectations back up and find where there’s equilibrium."

Benchmark 10-year note yields rose three basis points, or 0.03 percentage point, to 1.92 percent, as of 5 p.m. in New York, according to Bloomberg Bond Trader data. The price of the 1.625 percent security due in February 2026 fell 7/32, or $2.19 cents per $1,000 face amount, to 97 14/32.

Caution ‘Warranted’

Treasuries fell every day last week, the longest run of declines since November. They have dropped 0.5 percent in April, heading for the first monthly loss this year, based on the Bloomberg U.S. Treasury Bond Index.

The 10-year yield dropped eight basis points on March 29, the biggest one-day decline in nearly two months after Fed Chair Janet Yellen said that “caution is especially warranted” in raising rates because of global economic headwinds and remaining slack in labor markets, even as she made clear that policy makers could quickly reverse course if needed. The yield is now back to the pre-speech level.

“The market was surprised, as were we, how concerned she is with external factors, external influences,” Scott Thiel, BlackRock Inc.’s deputy chief investment officer for fundamental fixed income, said in a Bloomberg TV interview. “So in many respects is she going to be less concerned about China, a little less concerned about oil prices and therefore focus on the U.S. economic situation? In which case, she should move more quickly than markets expect on monetary policy.”

Thiel added that looking at the U.S. economy, this level of Fed accommodation “is not really necessary at this point.”

Futures traders have boosted the probability they assign to a Fed rate increase in 2016 to 64 percent from 49 percent a week ago, even as they see zero chance of an April move.

“Raising rates now may undo what they hope to accomplish with the rate increase,” said FTN’s Vogel, who expects the Fed will wait until July or September. “The idea of normalization is that the economy can deal with normal rates. We don’t have evidence of that yet."

Treasury Auctions

The U.S. sold $26 billion of two-year notes Monday at a yield of 0.842 percent, down from 0.877 percent in March. The Treasury will sell $34 billion of five-year debt Tuesday. It plans to auction seven-year securities and two-year floating-rate debt on April 28. It’s staying out of the market on April 27, the day of the Fed decision.

With U.S. debt yielding more than other developed-market peers, "people will find interest in that and the auctions will go well,” said Charles Comiskey, head of Treasury trading in New York at Bank of Nova Scotia, one of the 23 primary dealers that trade with the Fed.

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