TIPS at a tipping point? Traders say yes

Inflation still AWOL; notes linked to price hikes losing luster

Jan 24, 2011 @ 10:02 am

There has been no better place in the U.S. government bond market since 2008 than in debt that protects against faster inflation. Now, traders say the securities may be poised to fall as consumer prices rise too slowly to justify the gains.

Treasury Inflation-Protected Securities returned 17 percent the last two years, compared with gains of 1.9 percent in Treasuries, Bank of America Merrill Lynch indexes show. Yields on 10-year TIPS show bondholders expect the consumer price index to increase 2.18 percentage points a year on average over the life of the debt. The rate rose 1.5 percent in 2010 and is forecast to climb 1.7 percent this year, based on a Bloomberg survey of more than 60 economists.

“We're nowhere near any inflationary type of levels,” said Gary Pollack, who helps oversee $12 billion as head of fixed-income trading at Deutsche Bank AG's private wealth unit in New York. “There's a lot of slack in the U.S. economy, especially in the labor market. It's too soon to get too bullish on TIPS.”

The mismatch in expectations may suggest the portion of the U.S. government bond market established in 1997 as a buffer against inflation may be losing some of its predictive power.

Breakeven Rates

Demand for TIPS has pushed the difference between yields on the debt and non-inflation-linked Treasuries, known as the breakeven rate, as high as 2.42 percentage points this month on 10-year debt, up from 1.47 percentage points in August, on concern that the Federal Reserve's plan to buy $600 billion of Treasuries would spark faster inflation as the central bank prints more cash.

Break-even rates advanced on Jan. 5 to within 21 basis points of the 263 level reached in July 2008 when oil touched a record $147.27 a barrel and as consumer prices rose 5.6 percent, the most since 1990. Crude fell 2.7 percent last week to $89.11.

The break-even rate exceeded the consumer price index by as much as 132 basis points, or 1.32 percentage points. Since 1998, it has averaged 43 basis points less than CPI, according to data compiled by Bloomberg.

“A lot of the fears of the inflation hawks are going to be priced out of the market in the coming months,” said Eric Van Nostrand, a New York-based TIPS strategist at Credit Suisse Group AG.

Bond Auction

The Treasury's sale of a record $13 billion in 10-year notes on Jan. 20 showed waning demand for inflation-linked debt. The auction received the fewest bids per dollar of the debt sold since April 2009, with a 2.37 bid-to-cover ratio. The previous 10 sales had an average 2.73 ratio. The break-rate fell 14 basis points the next day, the biggest drop since May 20.

TIPS pay interest on a principal amount that rises with consumer prices. Their face value is protected against deflation, because the principal can't fall below par.

U.S. inflation-indexed debt has been a sweet spot for government bond investors, with an average annualized 8.2 percent gain the past two years, compared with 1 percent for the whole Treasury market, Merrill Lynch indexes show.

The yield on the 1.25 percent TIPS maturing in July 2020 rose 13 basis points to 1.06 percent last week. At the same time, the yield on the 10-year Treasury note jumped 8 basis points to 3.40 percent, according to BGCantor Market Data.

The TIPS rate was 1.08 percent, and the 10-year Treasury yielded 3.43 percent today as of 10:30 a.m. in London.

Record Deficits

TIPS sales are increasing as the government sells record amounts of bonds to fund the federal budget deficit projected to top $1.2 trillion for a third year.

Treasury will auction $120 billion to $125 billion of TIPS in 2011, after boosting issuance by 48 percent to a record $86 billion last year, according to Barclays Plc and Credit Suisse estimates. The total amount of marketable U.S. debt outstanding increased by 22 percent to $8.86 trillion in 2010.

Larger sales may attract investors who had avoided the market on concern too few bonds restricted trading and made the debt too risky, said Michael Pond, co-head of interest-rate strategy at Barclays in New York.

“Where we find value is as an inflation insurance play,” Pond said. “The Fed is keeping its foot on the accelerator despite the fact that data has been coming in better the past couple of months.”

The economy will grow 3.1 percent in 2011 and 3.15 percent in 2012, according to the median forecasts in Bloomberg surveys. The median growth forecasts in October were for 2.4 percent expansion in 2011 and 3 percent in 2012.

Commodities, Fed

Inflation may accelerate after commodities including corn, cotton and crude oil rose 26 percent since August as measured by the Thomson Reuters/Jeffries CRB Index. That's when Fed Chairman Ben S. Bernanke said he was considering resuming purchases of bonds to inject cash into the financial system to help bolster the flagging economic recovery.

Prices have become a larger concern in emerging markets, with central banks in China, Brazil and India raising borrowing to keep inflation from accelerating. Policy makers in Russia are considering their first rate increase since 2008 after consumer prices rose at an annualized 8.8 percent pace in December, up from 5.5 percent in July.

Global food costs jumped 25 percent last year to a record in December, according to the United Nations. In the U.S., the largest exporter, retail food rose 1.5 percent last year and will gain as little as 2 percent in 2011, the Department of Agriculture estimates.

Seeking ‘Proof'

U.S. consumers haven't been squeezed so far, though grocers from Jacksonville, Florida-based Winn-Dixie Stores Inc. to SuperValu Inc. in Eden Prairie, Minnesota, have said they plan price increases. Commodities will keep rising, according to a Bloomberg survey of more than 100 analysts and traders.

The faster inflation that TIPS breakeven rates are forecasting may reflect their correlation with commodities, stocks and high-yield bonds rather than higher prices, said George Goncalves, head of interest-rate strategy at primary dealer Nomura Holdings Inc. in New York.

“I need to see the proof in the pudding,” Goncalves said. “You know inflation is happening if stocks go down and TIPS stay where they are.”

The last time that happened was in the period from October 2007 through July 2008, when breakevens rose to 2.6 percentage points from 2.3 percentage points while the Standard & Poor's 500 Index plunged 16 percent as the Fed cut borrowing costs to counter the housing crisis.

Fed Meeting

Fed policy makers meet tomorrow and Jan. 26 to set monetary policy. The last time they gathered, on Dec. 14, they expressed frustration that the rate of inflation was too low.

“Currently, the unemployment rate is elevated, and measures of underlying inflation are somewhat low,” policy makers said in their Dec. 14 statement. While the Fed “anticipates a gradual return to higher levels of resource utilization in a context of price stability, progress toward its objectives has been disappointingly slow,” they said.

The Fed's preferred measure of inflation, consumer spending excluding food and energy, held at a record low for a second month of 0.8 percent for the 12 months ended November, the Commerce Department said Dec. 23.

The Fed's commitment to buying more Treasuries and the rise in commodity prices has “translated into people feeling the need to buy some inflation insurance,” pushing breakeven rates to levels that are unattractive, said Martin Hegarty, co-head of global inflation-linked portfolios at BlackRock Inc.

CPI Outlook

Hegarty, whose New York-based firm oversees about $1 trillion in bonds, says he favors TIPS maturing in 20- to 30- years over those due in 10 years.

Consumer prices will rise 1.7 percent in 2011 and 1.9 percent in 2012, according to the median forecasts in a survey on Jan. 13 by Bloomberg News. The unemployment rate will fall to 8.5 percent by the end of 2012 after ending this year at 9.3 percent, the median forecast in a separate survey showed.

“I don't think you can do a straight-line extrapolation of more optimistic growth prospects into higher near-term inflation,” said Wan-Chong Kung, who helps oversee more than $100 billion as a portfolio manager at Nuveen Asset Management in Minneapolis.

The economy will need to produce substantial growth and make use of unutilized capacity “before we can begin to meaningfully cut into that slack and meaningfully and sustainably create inflation,” she said.

--Bloomberg News--

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