U.S. inflation bond demand robust amid weak dollar

By Richard Leong

NEW YORK, Oct 26 (Reuters) - Monday's scramble for 5-year bonds that protect against inflation suggests that investors are uneasy about the potential of rising prices as the dollar weakens and government borrowing continues to surge.

Treasury Inflation-Protected Securities are an inflation hedge because the principal and interest payments on these bonds keep pace with a pickup in inflation.

The bidding for the $7 billion worth of TIPS offered by the Treasury Department was the strongest in 12 years, data showed, while the yield gaps between TIPS and regular Treasuries widened, reflecting persistent inflation concerns in some corners of the market.

The yield gaps, known as breakevens, briefly turned negative last year on the fear of possible deflation -- a sustained period of falling prices -- rather than inflation. They have been steadily widening this year, but are still at a historically narrow level.

"It was a great auction," said Michael Pond, Treasury and TIPS strategist at Barclays Capital in New York. "It's a realization that the market may have been pricing too low for inflation."

Monday's wider breakevens, however, will unlikely worry the Federal Reserve, which will hold a policy meeting next week. The Fed is widely expected to stick to the near-zero interest rate policy it adopted last December.

Most Fed policymakers seem more concerned right now in keeping a nascent U.S. economic recovery on track. High unemployment and a fragile housing market could derail the recovery, economists say.

The Fed's tolerance about inflation comes even as the weak U.S. currency has driven up the prices of gold, oil and other dollar-denominated commodities. If the price rise is sustained, it mean eventually higher costs for U.S. producers and consumers. For details, see [ID:nN26194750]

"Breakevens are still low and there are no indications that inflation expectations are getting out of hand," Barclays' Pond said.

Five-year breakevens grew to 1.61 percent on Monday from 1.57 percent late on Friday. This meant they were performing like regular five-year Treasuries. Five-year breakevens were at minus 0.22 percent at start of the year.

The five-year TIPS offering is part of this week's record $123 billion bond supply from the U.S. Treasury Department which issued more than $1.5 trillion new debt last fiscal year.

TIPS, created back in 1997, make up about 8 percent of the $6.6 trillion in U.S. government debt outstanding, according to the Securities Industry and Financial Markets Association.

Besides inflation concerns, Monday's sizzling TIPS auction results underscored increasing investor demand to diversify from regular Treasuries.

"In the beginning that was the TIPS selling point and (it) seems like the market is realizing this again today," said George Goncalves, head of interest rates strategy at Cantor Fitzgerald in New York.

The Treasury has asked bond dealers for feedback on how it should increase its issuance of TIPS amid rising demand from overseas central banks.

(Reporting by Richard Leong; Editing by Kenneth Barry)