Bond Rally Intensifies Inflation Debate
21 March 2017 - 9:34AM
Dow Jones News
By Min Zeng
A rise in U.S. government-bond prices since the Federal
Reserve's latest rate increase underscores investors' continuing
skepticism about inflation.
The yield on the 10-year Treasury note fell to 2.472% Monday,
extending a decline since the Fed move on Wednesday, when yields
were near their highest level in more than two years at 2.6%. Bond
yields fall when prices rise.
Inflation has risen in recent months after spending years below
the Fed's target, prompting many investors and analysts to search
for signs of a breakout. Higher inflation chips reduces investors'
real purchasing power, reducing the appeal of fixed-rate bond
investments.
The U.S. economy is near the Fed's definition of full
employment, and data in the U.S. and other developed economies say
consumer prices are rising, increasing the pressure on central
banks to pare stimulative policy.
Yet a survey-based gauge of U.S. consumer inflation expectations
over the next five to 10 years hit a record low this month,
according to a release from University of Michigan on Friday, and
some market-based measures show little change in recent months.
The debate underscores the uncertainty over the prospects for
U.S. growth and asset prices in coming years. Long-term rates have
risen since Donald Trump's election as president, reflecting
expectations the administration will boost fiscal spending and cut
taxes, but many investors question the pace at which his
economic-policy proposals might take effect.
"The reflation story may not be a long-lasting one," said Lynn
Chen, senior portfolio manager at Aberdeen Asset Management.
Many market-based inflation readings highlight this skepticism.
The 10-year break-even rate, which measures the yield premium on
the 10-year Treasury note relative to comparable Treasury
inflation-protected securities, was 2.01 percentage points Monday.
That reflects investors' expectation of an annual 2.01% rate of
inflation over the next 10 years, nearly the same as the 2% reading
on the five-year break-even rate.
The 10-year break-even rate should be higher than the five-year
rate if investors expect inflation to flare up, say some
investors.
The Fed raised rates last week for a third time since the
financial crisis and signaled a gradual pace in tightening policy
amid tentative signs of a shift away from a prolonged period of
weak growth and low inflation.
David Rosenberg, chief economist and strategist at Gluskin Sheff
& Associates Inc., said there has been a 73% correlation
between inflation expectation data from University of Michigan and
the 10-year Treasury yield. That means the two variables move in
tandem 73% of the time.
Federal Reserve Bank of Minneapolis President Neel Kashkari, the
only member of the Fed's policy committee to dissent from last
week's rate increase, cited inflation as a key reason for his vote
in a Friday statement.
"Inflation is still below our target," he wrote. "While there
are some signs of inflation slowly building toward our target, it
isn't happening rapidly, and inflation expectations appear
well-anchored."
U.S. consumer prices rose by an annualized pace of 2.7% in
February, well above the Fed's 2% target. Yet the Fed's preferred
inflation gauge -- the personal-consumption expenditures price
index -- has risen at a more subdued pace. The PCE was up 1.9% over
the past 12 months in January. Excluding energy and food, the
so-called core PCE was up 1.7%.
Some investors say the upticks in inflation are a sign of a
brighter growth outlook.
Demand for TIPS has been robust, reflecting growing appetite
from investors for inflation protection. TIPS holders get extra
payments when inflation rises above certain thresholds. U.S. mutual
bond funds and exchange-traded funds targeting TIPS attracted a net
$246 million new cash for the week that ended March 15, bringing
the year-to-date total to $5.3 billion, according to data from fund
tracker Lipper.
A slow rise in inflation benefits the economy because it boosts
the prospect of higher compensation for workers, increases tax
revenue for the federal government and reduces the real burden of
debt payments. Some see the rise as a normalization of inflation,
making it easier for major central banks to fulfill their inflation
mandate.
This environment has been emboldening investors to chase riskier
assets for better return. U.S. stocks trade near record highs and
emerging market stocks and bonds have also attracted robust demand
this year.
"We welcome inflation returning toward trend particularly given
the low level of productivity and wages," said Gemma
Wright-Casparius, senior portfolio manager of the fixed-income
group at the Vanguard Group.
Deepa Majmudar, money manager at J.P. Morgan Asset Management,
cautions that investors may underestimate the risk of long-term
inflation.
"Many have been so used to low inflation over the past decades,"
so they may be caught off guard by "an inflation shock," she
said.
Write to Min Zeng at min.zeng@wsj.com
(END) Dow Jones Newswires
March 20, 2017 18:19 ET (22:19 GMT)
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