Inflation fear back in play in U.S. bond market

By Chris Reese - Analysis

NEW YORK (Reuters) - The flight-to-safety play that has dominated U.S. Treasury market trading for much of the last year is giving way to a flight-from-inflation trade.

Beginning last summer, the slump in the U.S. real estate and mortgage securities markets kept Treasuries on a tear as investors feared recession and shied from any financial asset associated with risk.

Now, though, as the notion that the worst of the credit crisis may have passed gains traction, investors are turning their attention to inflation, and that has some bond mavens signaling retreat.

Bond prices are indeed well off their highs from mid-March, though yields, while sharply higher, remain below the rate of inflation on all but the longest of maturities, the 30-year bond. That means that many bond holders effectively have a negative rate of return, and investors appear to wising up to that fact.

"We may in fact already be seeing that turn. You may argue that the bounce in bond yields has been pretty solid," said Michael Englund, economist at Action Economics in Boulder, Colorado. "People are taking their eye off the recession ball and perhaps recognizing that we have got a pretty solid inflation story."

Consistently strong price pressures are getting more notice in the bond market, especially with oil shooting north of $123 a barrel, retail gasoline costs threatening $4 a gallon and basic food staples such as rice nearly doubling in price since the year began.

The producer price index on a year-over-year basis rose 6.9 percent in March, marking the sixth consecutive month that headline PPI was above 6.2 percent.

The last time that producer inflation held at those levels for six consecutive months was in late in 1981, when benchmark 10-year Treasury note yields were near 15.75 percent -- well above the current yield of about 3.90 percent, according to John Kosar, president of Asbury Research in Chicago.

Also, the headline consumer price index has been running at or above 4 percent on a year-over-year basis for five consecutive months as of March, and is forecast to have held there again in April. The last time it consistently ran at those levels was early in 1991, when the 10-year Treasury note yield traded mostly above 8 percent.

"There is a tremendous disconnect between inflation levels and Treasury yields," said Dean Baker, co-director of the Center for Economic and Policy Research in Washington. "I don't understand why many investors are still holding 10-year Treasuries ... it seems like such a sure loser."

With the exception of the 30-year bond yield, all other Treasury note yields are below the headline CPI rate.

Treasury bond yields have generally been rising, and prices falling for about two months as more analysts consider the possibility that the worst of a global credit crisis may be over.

However, bond yields overall have fallen since last summer as investors have sought out safe-haven investments from the credit crunch, with the 10-year yield dipping from near 5.30 percent since June.

Part of the most recent rise in yields has also been based on inflation worries as food and energy costs have soared to new records.

Many analysts believe that rising inflation has crimped the Federal Reserve's ability to cut interest rates any further to prop up the sagging economy, and that the central bank may even have to start raising rates soon in an effort to stifle inflation.