April 28, 2008 / 5:10 AM / in 11 years

Bond investors bet on rate hikes as inflation looms

TOKYO/LONDON (Reuters) - Investors rushed to bet on higher global interest rates on Friday, dumping bonds in the belief that major central banks were switching from nursing economies hobbled by a credit crisis to battling inflation.

Inflation has all but brought the U.S. Federal Reserve’s rate-cutting cycle to a halt, and there has been market speculation that the European Central Bank may have to raise rates after euro zone inflation hit record peaks. Even Japan, which has experienced a long period of low inflation, is starting to feel the pinch of rising prices.

The biggest shift in outlook has been for the Federal Reserve, which has slashed interest rates by 3 percentage points since September to cushion the U.S. economy from the fallout of the credit crisis — but now appears boxed in by record gasoline, crude oil and food prices.

The two-year U.S. Treasury yield US2YT=RR, the most sensitive to the outlook for rates, hit a high of 2.51 percent on Friday — leaping 26 basis points above the current federalfunds target rate, the most since June 2006. For details, see[US/].

Although the Fed is expected to trim rates once more at its policy-setting meeting next week, U.S. interest rate futures show most market participants expect the Fed to then pause its rate cut cycle. Futures imply that after cutting the target rate to 2 percent on April 30, the Fed’s next move may be a rate hike near year end.

The main Japanese bond futures contract 2JGBv1 suffered its biggest daily fall in five years, forcing the Tokyo Stock Exchange to call a trading halt for the first time ever.

In Europe, the contract resumed weaker than in London on Thursday. At the 4 p.m. London time (1500 GMT) close, the JGB contract was at 135.35, down 32 ticks on the day FYBc1.

The effects were felt by other fixed income assets too. Euro zone government bonds FGBLc1 initially fell on Friday, and U.S. Treasuries TYv1 took a hit in Asia and Europe.

In Japan, investors’ anxiety centered on the fact that a major economy which had for years experienced low inflation was beginning to feel the pinch of rising prices.

“Inflation has not been a problem in Japan for many years now, and, given that inflation is even reaching that part of the world, then it does really bring into focus how big a problem inflation could be potentially going forward,” said Orlando Green, fixed income strategist at Calyon.

“That’s really going to hurt the long end on the bond curve in the medium term, so that’s a big issue for the market.”

However, most of Friday’s selling was in short-dated paper.

European observers said JGB prices had probably found a floor and Japanese interest rates were not headed up to counter price inflation.

“The CPI numbers were the straw that broke the camel’s back and led to a spectacular collapse by Japanese bonds today. But, judging by the long list of subdued data Japan has had, I don’t think the authorities are going to hike interest rates anytime soon,” said Marc Ostwald, a bond analyst at Insinger de Beaufort in London. “Rates aren’t moving, except down.”

Although the Tokyo bond rout followed news that inflation in Japan had hit a decade peak, expectations of higher rates had been building for days on signs the global economy had seen off the worst of the turmoil ignited by U.S. mortgage defaults.

Analysts anticipate that the Fed may tweak the language of its post-meeting statement on Wednesday to reflect that it may be nearly finished after chopping rates from 5.25 percent in September. FEDWATCH.

Just a month ago, investors were looking for the Fed to cut rates as low as 1 percent to help revive the economy.

“We have had a repricing in the Treasury market because some fears have been alleviated, but as economic fundamentals weaken, the curve will re-steepen,” said Bob Gahagan, head of taxable bonds with American Century Investments in Mountain View, California.

By rising to 2.50 percent, the two-year Treasury note’s yield, which moves inversely to its price, has overshot, he said.

Yet, the Fed’s room to cut rates is limited, Gahagan added.

“The Fed is in a tight spot,” he said. “Our view is that inflation will continue be worrisome and a problem in 2008.”

“Pressures from food inflation aren’t going away anytime soon; the weaker dollar will still have an inflationary impact through 2008 and 2009,” Gahagan said. He said energy costs will add to inflation pressures, perhaps pushing up longer-maturity bond yields and steepening the gap of these over shorter maturities.

There has also been speculation this week that the European Central Bank could raise rates from 4.0 percent after euro zone inflation hit a record high, drawing warnings on price pressures from ECB policy-makers.

Japan's Nikkei average jumped 2.4 percent .N225 to a two-month high on Friday, reflecting the rising confidence among investors that the worst may be over, as opposed to fears about inflation. [.T]

The jump in short-term bond yields in the United States as well as Japan provided the clearest signal yet that investors believe central banks are focusing more on containing inflation than fostering growth.

In Japan, two-year government bond yields JP2YTN=JBTC shot up as much as 13 basis points to 0.850 percent — well above the BOJ’s 0.5 percent target because the next move is seen as a rate hike instead of a rate cut.

Euro zone two-year yields EU2YT=RR are up a full percentage point from their lows hit in March.

(Reporting by George Matlock in London, Eric Burroughs in Tokyo, Tomasz Janowski in Singapore and John Parry in New York; Editing by Jonathan Oatis)

george.matlock@thomsonreuters.com; Reuters Messaging: george.matlock.reuters.com@reuters.net; +44 20 7542 2508 Keywords: GLOBAL ECONOMY/BONDS

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