Fed and bond market face inflation, growth quandary

By Richard Leong and John Parry - Analysis

NEW YORK (Reuters) - The Federal Reserve is in a race against time to reassure the bond market it hasn't lost its grip on inflation while not losing sight of a U.S. economy still vulnerable to a recession.

Although most analysts do expect the Fed to hold its benchmark interest rate steady through the summer, traders are already sweating over the lurking dangers that could force the U.S. central bank's hand.

The U.S. dollar could fall again, commodity prices could continue to rise to new records, and other central banks could move first to raise interest rates to restrain inflation and leave the Fed standing.

"Some traders are worried the Fed may have lost its grip on inflation," said Rob Kurzatkowsi, an analyst at optionsXpress in Chicago.

First to sound the alarm may be the U.S. Treasury bond market which is already nervous that the Fed may leave U.S. consumers at the mercy of spiraling inflation.

If U.S. consumer inflation expectations, already at an eyebrow-raising 7.7 percent, continue to accelerate this summer, bond yields may rise further in anticipation of a rate rise from the Fed in the fall.

"What do fixed income investors desire? A positive real return on their money," said Michael Pento, senior market strategist with Delta Global Advisors in Huntington Beach, California.

"As time goes by and as fact that inflation is the new paradigm is accepted by investors, they will have to price it into the Treasury market and I would not be surprised if yields (of 10-year notes) are significantly above 5 percent by the end of the year," said Pento.

Currently U.S. CPI inflation is running above 4.0 percent annually meaning most longer term U.S. Treasury bond yields are barely covering inflation or maintaining investor purchasing power.

WITHERING EXPECTATIONS

The deterioration in inflation expectations on Main Street has been reflected on Wall Street. One of the troubling signposts is the rapid expansion of the "breakevens" or the yield difference between Treasury Inflation-Protected Securities and regular Treasury notes and bonds.

The breakevens between 10-year TIPS and 10-year Treasuries, a market gauge monitored by the Fed, have widened by a quarter percentage point from a month ago.

"That the Fed should raise rates against inflation is

absolutely abundantly clear to me," Pento said.

Last week, hawkish remarks from Fed officials roiled the Treasury market, pushing yields to fresh highs for the year.