Improving Economy Sparks Rebound in Inflation Bets

A measure of the bond market’s expectations for inflation crossed a key threshold in the past week, highlighting investors’ renewed economic enthusiasm.

The 10-year inflation break-even rate, which reflects the yield premium on the 10-year U.S. Treasury note over the comparable Treasury inflation-protected security, topped 2% on Tuesday for the first time in more than nine months, according to Thomson Reuters. It settled Friday at 2.027%, its highest level since March 16.

Two-percent is an important level for the break-even rate because it matches the Federal Reserve’s annual target for inflation, which has puzzled economists by remaining soft in recent months despite improvement in other aspects of the economy.

The break-even rate hovered around 1.8% in November before gathering momentum as energy prices rose and as Congress moved forward with a plan to cut corporate taxes, which is expected to boost growth around 0.5% in 2018, according to BNP Paribas.

With many investors expecting the economy to continue expanding at or near the 3.2% pace it recorded in the third quarter, and with the unemployment rate having held at 4.1% for a third consecutive month in December, investors are increasingly focusing on the potential for prices to rise. One channel they are scrutinizing is wages, which some expect to pick up substantially as the labor market tightens further.

The break-even rate has climbed in recent weeks as investors bought Treasury-inflation protected securities, or TIPS, and sold regular Treasurys, a typical strategy when they see a risk of rising inflation. Investors in TIPS receive a small yield as well as an increase to their principal equal to the annual change in the consumer-price index.

“TIPS have certainly had a nice run,” said Donald Ellenberger, head of multisector strategies at Federated Investors. Mr. Ellenberger increased TIPS holdings to 5% of multisector funds from 3% in November. “It’s been a winner for us.”

U.S. mutual funds and exchange-traded funds targeting TIPS drew a net $625 million in the week ended Wednesday, according to Wells Fargo Securities.

Investors are betting on TIPS even as inflation remains below the Fed’s target and as the central bank has embarked on a course of rate increases intended to prevent higher prices from taking root in the economy.

The CPI increased 2.2% in November from a year earlier. However, the Fed’s preferred inflation gauge, the price index for personal-consumption expenditures, rose just 1.8% on a headline basis and 1.5% when excluding volatile food and energy costs. The Fed measure tends to run about 0.3 percentage point below the CPI, according to Barclays PLC.

Fed officials have signaled their intention to raise rates three times in 2018. Some economists, including those at JPMorgan Chase & Co., have said they expect the central bank to be even more aggressive in damping price pressures, predicting four increases this year.

While some investors may not be convinced that inflation is going to rise, buying TIPS can still be an appealing hedge. Because bond yields have been near historic lows for so long, investors are obtaining very little income from interest payments, which means rising prices would have “a really detrimental impact on a bond portfolio,” Mr. Ellenberger said.

Signs investors are concerned about higher inflation aren’t confined to the bond market. Commodities such as oil, copper and aluminum — which are key industrial materials and often serve as bellwethers for the direction of consumer prices — are also rallying. So is gold, which has historically served as a store of value in times when inflation has been a concern.

Still, some investors are hesitant to ride the current trend, noting that inflation expectations have climbed before in recent years, only to fall back down again.

Given recent history, long-term investors “are all a little hesitant to say that this is the moment that inflation expectations should be breaking out,” said Dan Dektar, a portfolio manager and head of liquid markets at Amundi Pioneer.
Source: Dow Jones

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