There has been no better place in the U.S. government bond market since 2008 than in debt that protects against faster inflation
There has been no better place in the U.S. government bond market since 2008 than in debt that protects against faster inflation.
Traders contend that the securities may be poised to fall as consumer prices rise too slowly to justify the gains.
Treasury inflation-protected securities have returned 17% over the past two years, compared with gains of 1.9% in Treasuries, Bank of America Merrill Lynch indexes show. Yields on 10-year TIPS show that 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% last year and is forecast to climb 1.7% 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. “It's too soon to get too bullish on TIPS.”
The mismatch in expectations may suggest that 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.
BREAK-EVEN RATES
Demand for TIPS has pushed the difference between yields on the debt and non-inflation-linked Treasuries, known as the break-even 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 will spark faster inflation as the central bank prints more cash.
Break-even rates advanced 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%, the highest level since 1990. Crude was down to about $86 last week. The break-even rate exceeded the CPI by as much as 132 basis points. Since 1998, it has averaged 43 basis points less than the 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 TIPS strategist at Credit Suisse Group AG.
The Treasury Department's sale of a record $13 billion in 10-year notes 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-even 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% gain the past two years, compared with 1% for the whole Treasury market, Merrill Lynch indexes show.
The yield on the 1.25% TIPS maturing in July 2020 rose 13 basis points to 1.06% last week. At the same time, the yield on the 10-year Treasury note jumped 8 basis points to 3.4%, according to BGCantor Market Data.
RECORD DEFICITS
TIPS sales are increasing as the government sells record amounts of bonds to fund the federal budget deficit, which is projected to top $1.2 trillion for a third year.
The Treasury Department will auction $120 billion to $125 billion of TIPS in 2011, after boosting issuance by 48% 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% to $8.86 trillion last year.
Larger sales may attract investors who have avoided the market on the concern that too few bonds have restricted trading and made the debt too risky, said Michael Pond, co-head of interest rate strategy at Barclays.
“Where we find value is as an inflation insurance play,” he said.
The economy will grow 3.1% this year and 3.15% in 2012, according to the median forecasts in Bloomberg surveys. The median growth forecasts in October were for 2.4% expansion in 2011 and 3% in 2012.
Inflation may accelerate, as commodities, including corn, cotton and crude oil, have risen 26% since August as measured by the Thomson Reuters/Jefferies CRB Index. That was when Fed Chairman Ben S. Bernanke said that 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 Brazil, China and India raising borrowing to keep inflation from accelerating. Policymakers in Russia are considering their first rate increase since 2008 after consumer prices rose at an annualized 8.8% pace in December, up from 5.5% in July.
Global food costs jumped 25% last year to a record in December, according to the United Nations. In the United States, the largest exporter, retail food rose 1.5% last year and may be up only 2% in 2011, the Agriculture Department estimates.
U.S. consumers haven't been squeezed so far, though grocers from Winn-Dixie Stores Inc. to SuperValu Inc. have said that 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 break-even 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.
“I need to see the proof in the pudding,” he 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 between October 2007 and July 2008, when break-evens rose to 2.6 percentage points, from 2.3 percentage points, while the S&P 500 plunged 16% as the Fed cut borrowing costs to counter the housing crisis.
The Fed's commitment to buying more Treasuries and the rise in commodities prices have “translated into people feeling the need to buy some inflation insurance,” pushing break-even rates to levels that are unattractive, said Martin Hegarty, co-head of global inflation-linked portfolios at BlackRock Inc.
Mr. Hegarty, whose firm oversees about $1 trillion in bonds, said that he favors TIPS maturing in 20 to 30 years over those due in 10 years.
Consumer prices will rise 1.7% this year and 1.9% in 2012, according to the median forecasts in a survey Jan. 13 by Bloomberg News. The unemployment rate will fall to 8.5% by the end of 2012 after ending this year at 9.3%, 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 Inc. 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.
