Inflation on the rise? Market says not so much

Options traders push out Treasury market sell off expectations

Oct 1, 2012 @ 10:08 am

Bill Gross, who runs the world's biggest bond fund, says the Federal Reserve's open-ended plan to flood the economy with $40 billion a month will ignite inflation. The options market is signaling that won't happen anytime soon.

Demand to protect against higher long-term bond yields over the next six months has been static since Fed Chairman Ben S. Bernanke announced a third round of quantitative easing, or QE3, Sept. 13, Barclays Plc data shows. Appetite, though, is rising for options that mature in 2015. Traders' expectations for consumer price increases as measured by inflation-protected Treasuries have fallen from highest levels since 2006.

The market measures show tame inflation is giving Bernanke time to nurse the economy back from the depths of the worst financial crisis since the Great Depression without pressure to withdraw stimulus just as $1.2 trillion in mandated fiscal spending cuts and tax increases start Jan. 1. Consumer prices are in check though the Fed pumped $2.3 trillion into the economy through QE bond purchases since 2008.

“The market is not suggesting there's any kind of runaway inflation in the next one or two years given the below trend growth trajectory and the impending fiscal cliff,” said Gemma Wright-Casparius, who manages the $43.9 billion Vanguard Inflation-Protected Securities Fund at Valley Forge, Pennsylvania-based Vanguard Group Inc.

Bond Rally

Treasuries have returned 41 percent since mid-2007 when including reinvested interest, according to Bank of America Merrill Lynch indexes. That's better than the 7.52 percent gain for the Standard & Poor's 500 with dividends.

Yields on 10-year notes fell 12 basis points last week, or 0.12 percentage point, to 1.64 percent in New York, according to Bloomberg Bond Trader prices. The price of the benchmark 1.625 percent security due August 2022 rose 1 2/32, or $10.63 per $1,000 face amount, to 99 29/32. The yield was 1.63 percent at 9:31 a.m. New York time.

Even as speculation mounted in recent months that the Fed would undertake a third round of QE, a policy that risks igniting inflation by debasing the dollar and assets denominated in the currency, economists and strategists have grown more bullish on bonds.

The median of 78 estimates is for 10-year yields to end the year at 1.75 percent, and finish 2013 at 2.4 percent. In April, the survey estimated yields at 3 percent by the start of 2014, still below the average of about 7 percent since 1970. Yields are down about 0.25 percentage point this year.

Payer Skew

The Barclays data measures what traders call the payer skew using options on interest-rate swaps. The skew typically widens when traders anticipate a rise in yields as they seek to hedge the value of their holdings. It's now 25 cents for the shorter term, about unchanged from December, while it's 89 cents for options that mature in 2015, up from 80 cents at the end of 2011. Each 10 cents represents $100,000 of bonds.

“The options market is pushing expectations of a violent sell off in the Treasury market further into the future,” said Piyush Goyal, a fixed-income strategist in New York at Barclays, in a telephone interview on Sept. 21.

Goyal and his colleagues including Amrut Nashikkar were No. 2 this year in Institutional Investor magazine's survey of U.S. money managers in the category of best strategists for interest- rate derivatives behind JPMorgan Chase & Co.

Fed Plan

The Fed said Sept. 13 that it would buy $40 billion of mortgage bonds a month until the U.S. sees what Bernanke described as an “ongoing, sustained improvement in the labor market.” The central bank also said it would probably hold the federal funds rate near zero at least through mid-2015. Since January, it had said the rate was likely to stay low at least through late 2014.

Gross, who manages the $272 billion Total Return Fund at Newport Beach, California-based Pacific Investment Management Co., wrote on Twitter the day after the Fed's announcement that the central bank would “buy mortgages 'til the cows come home'' and that investors should ''buy real house!'' He wrote on Sept. 18 that ''we are in an age of inflation.''

While his fund has gained 9.09 percent this year, beating 97 percent of its peers, it lagged behind in 2011 with a 4.16 percent return, underperforming 69 percent of rivals as Gross wrongly bet Treasury yields would rise, data compiled by Bloomberg show. He cut the fund's holdings of U.S. government bonds last month to the lowest level since October, or 21 percent of assets.

Election Issue

The consumer price index rose 1.7 percent in August. Bond yield have been mostly below the gauge since April 2011, resulting in negative real yields.

The Fed's actions have become an issue in the U.S. presidential race. Representative Paul Ryan of Wisconsin, the Republican vice-presidential candidate, said Sept. 12 that if Mitt Romney is elected, he would focus on ''sound money” to prevent stagflation, referring to an environment of low growth and high inflation last seen in the 1970s.

Romney and President Barack Obama will debate economic policy Oct. 3 in Denver.

Investors initially increased their inflation expectations on the Fed's plan. The gap between yields on 10-year notes and same-maturity Treasury Inflation-Protected Securities, or TIPS, widened to 2.73 percentage points on Sept. 17, the highest level since May 2006. The so-called break-even rate, which measures how much traders anticipate consumer prices will rise over the life of the debt, narrowed last week to 2.42 percentage points.

Inflation Credibility

“The Fed will be proven right, that hyper-inflation will not be a consequence of their actions and that they will be able to execute an exit strategy well before those consequences may surface,” Wan-Chong Kung, a money manager in Minneapolis at Nuveen Asset Management, said in a Sept. 25 interview, referring to a tightening of policy. Nuveen oversees more than $100 billion in bonds.

The Fed has built up three decades of inflation-fighting credibility, first with Paul Volcker and then with Alan Greenspan, with the consumer price index average 2.2 percent over the last 5 years, down from almost 15 percent in 1980.

“For the last thirty years the central bank has done everything they can to increase inflation credibility,” Eric Green, global head of rates and foreign-exchange research at TD Securities Inc. in New York and a former economist at the New York Fed, said in an interview on Sept. 25. “Now they are withdrawing the deposit on that.”

Wages, Spending

Bernanke is getting help from the weak labor market. The government may say Oct. 5 that the unemployment rate held above 8 percent for the 44th straight month in September, according to the median estimate of more than 60 economists by Bloomberg.

Wages grew 1.7 percent in August from a year earlier, down from more than 3.5 percent in early 2009. Consumer spending rose 0.1 percent in August after adjusting for inflation following a 0.4 percent gain in July, the Commerce Department said Sept. 28.

“Our policy approach doesn't involve intentionally trying to raise inflation,” Bernanke said in response to a question during a Sept. 13 press conference. “The idea is to make sure we provide enough support so the economy will grow fast enough to bring unemployment down over time.”

The Fed's own measure of inflation expectations, the five- year, five-year forward breakeven rate was 2.68 percent on Sept. 26, after reaching a 13-month high of 2.88 percent the day after the Fed's QE3 announcement. The gauge projects the expected pace of consumer price increases over the five year period beginning 2017.

Investors “pushing break-even rates higher are concerned about medium-term to longer-term inflation, or that is, two to five years from now,” said William O'Donnell, head U.S. government-bond strategist at RBS Securities Inc. in Stamford, Connecticut, one of 21 primary dealers that trade with the central bank. “The inflation that we are pretty sure the Fed fears most, wage inflation, shows no imminent threat.”

(Bloomberg News)


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