Inflation alarm after oil surge

LONDON (Reuters) - Inflation will be back at center-stage for financial markets this week with oil’s surge past $70 a barrel and rising bond yields rekindling worries about long-term borrowing costs and the fragile housing sector.

A series of inflation readings for May in the United States, Britain and the euro zone will focus investors’ minds after oil prices jumped over 20 percent last month and bond markets were spooked enough to lift 10-year U.S. Treasury yields to 4 percent -- an eight-month high.

“Against an increasing global oil and agricultural commodity price backdrop, we see a reasonable chance that market headline inflation concerns maintain in the coming weeks,” Barclays Capital said in a recent note to clients. Economic data has strengthened investors’ conviction that economic recovery is taking hold, and that has driven rallies in equities, commodities and riskier emerging markets assets.

This is thanks to governments’ stimulus measures and unprecedented quantitative easing programs by central banks which have led to rock-bottom interest --and mortgage -- rates.

But the rise in longer-dated Treasury yields, linked to huge issuance volumes and some doubts about demand for U.S. assets, is causing fears for the fragile recovery as it heralds higher borrowing costs down the line.

And the healthy data together with super-loose monetary policy has also served to bring inflation -- on the backburner for months -- back on the agenda.

“There is a debate going on whether the spare capacity opening up will allow inflation to stay low for a prolonged period of time, but markets don’t seem to be buying this view,” said Sarah Hewin, senior economist at Standard Chartered.

Markets’ inflation fears appear to stem from the potential impact of quantitative easing, as well as the recent slew of positive economic data, Hewin said.

But she added: “We don’t buy the view that the extent of QE we have seen will bring a resurgence of inflation -- at least until the end of 2010 and we think U.S. Treasury yields may have backed up too far.”

Paul Mortimer-Lee at BNP Paribas agreed, predicting bond yields to ease in the second half of the year.

“There are entirely legitimate reasons to be concerned about inflation longer term -- the monetization of government debt and the too late removal of accommodation being amongst them,” Lee told clients.

“(But) in the next year or two, we believe deflation is a more pressing problem.”


Fund managers may need some convincing, however.

The rally that has propelled emerging equities up 40 percent year-to-date and developed stocks up some 50 percent from their March troughs seems to have run out of steam for now, though a well-bid U.S. Treasury auction on Thursday helped reassure investors somewhat and brought yields down a touch.

World stocks hit new 8-1/2 month highs after the auction but markets lack the conviction to advance much further from here, analysts say.

Weak euro zone production data on Friday added to the stocks uncertainty as it raised risks that second quarter company results will be poorer than forecast.

Emerging stocks have also lacked the conviction to break higher after gaining some 70 percent from March lows, with a recent devaluation scare in tiny Latvia providing an added reminder of the risks of investing in emerging markets.

“We’re in an intermediate positive trend where you have fundamental reasons to be positive that there is no imminent relapse into a dire global funding situation,” said Ralph Sueppel, chief economist at Bluecrest Capital in London.

“Credit is being massively subsidized by governments around the world. But fiscal issues are set to get a lot more prominent in the fall when governments begin to draw up their 2010 budgets ... There seems to be no elegant way out of this predicament and there’s no exit strategy.”

The exit strategy is what policymakers are debating at the meeting in Italy of the G8 group of industrialized nations. The world’s leading powers are looking for a way to ultimately withdraw the huge fiscal and monetary stimulus that could eventually lead to higher inflation.

A related concern for holders of U.S. Treasuries is the fate of the dollar -- a topic that investors will hear more about from a summit of BRIC emerging nations next week in Russia.

Brazil, Russia, India and China -- among the biggest holders of U.S. Treasuries -- are set to debate the dominance of the U.S. dollar though Asian powers have made it clear they will not push to dethrone the greenback as the world’s reserve currency.

Fears that U.S. assets may lose their “safe haven” status have contributed to the greenback’s broad weakness against other major currencies, especially the euro. However, analysts say no consensus is likely to emerge from the June 16 summit, with Russia leading the thrust against the dollar.

“Although the rhetoric from Russia may add to dollar worries, the reality is that it is highly unlikely that any form of concrete plan will be easily developed to shift away from the dollar,” Calyon analysts told clients. “It would be self- defeating for foreign official investors to move quickly out of dollar assets.”

Additional reporting by Sebastian Tong; editing by Stephen Nisbet