January 10, 2018 / 6:20 PM / in 11 days

Bets on U.S. inflation heat up in bond market

NEW YORK (Reuters) - More investors are favoring U.S. bonds that profit from a pickup in inflation as the global economy gathers momentum with oil and other basic commodity prices recently hitting multi-year highs.

As a result, market forces in key economies and efforts by their policymakers might finally be aligning to lift inflation to 2 percent, a level the Federal Reserve and its counterparts in the euro zone and Japan desire but have failed to see for years, analysts and investors said.

If U.S. inflation hits that elusive level, Treasury Inflation Protected Securities could score solid gains in 2018, producing higher returns than regular U.S. government bonds.

“There’s global synchronized economic growth. Inflation is heading upward,” said Com Crocker, senior inflation analyst at New Century Advisors based in Chevy Chase, Maryland.

That upbeat view spurred $465.50 million of cash into funds that focus on TIPS in the week ended Jan. 3, bringing their total assets to an all-time peak of $67.39 billion, according to Lipper, a Thomson Reuters mutual fund research unit.

Last week’s net inflows into TIPS mutual and exchange-traded funds were the most in 10 months.

In the United States, inflation could be on the cusp of breaking higher, with passage of the biggest overhaul of the U.S. tax code in 30 years in December supporting bets of at least a near-term boost to business investment and hiring.

Adding to that are expectations of further weakness in the dollar, just off its worst annual performance since 2003, which would make foreign-made goods more expensive in the United States.

Meanwhile in the euro zone, signs of regional inflation gathering momentum has stoked speculation the European Central Bank might not renew its stimulative 2.55 trillion euro bond purchase program when it expires in September.

And in Japan the central bank scaled back its bond purchases on Tuesday on signs of improving domestic growth, sparking a global bond market selloff on fears the Bank of Japan may pare back stimulus later this year.

These factors augur the case to owning TIPS, but the lack of U.S. wage acceleration despite the lowest jobless rate in 17 years has curbed a wholehearted embrace of the $1.3 trillion sector.

“There’s no pressure from wages,” said Fred Marki, portfolio manager at Western Asset Management Co. in Pasadena, California. “It’s not enough to create excess demand with rising inflation.”

BOND MARKET SELLOFF

Another reason against loading up on TIPS is the global selloff in bonds so far in 2018, which intensified on Wednesday following a Bloomberg report that China might slow or stop its purchases of U.S. Treasuries in a review of its foreign exchange holdings.

China is the biggest foreign holder of U.S. government debt, with holdings totaling $1.19 trillion as of October.

Still some investors are betting on more gains in TIPS as the yield gap between 10-year TIPS and regular 10-year Treasuries broke 2 percent last week for first time since March. It reached 2.05 percent on Wednesday.

This measure of investors’ inflation expectations in the next decade has risen steadily from 1.66 percent last June amid surges in the price of oil and other commodities.

On Wednesday, U.S. crude futures reached a three-year peak above $63 a barrel on tightening supply, while zinc hit a decade-plus high on Tuesday

TIPS’ APPEAL

While more investors see TIPS as an inflation hedge, with an improving economic backdrop some analysts see stocks, corporate bonds and other riskier investments producing higher returns than TIPS.

“We are thinking of adding a bit of TIPS. It’s not a bad place for fixed income investors, but a better place to beat inflation would be equities,” said Andrew Richman, director of fixed income with SunTrust Advisory Services in Jupiter, Florida.

In 2017, TIPS produced a 3.0 percent total return, a tad better than 2.3 percent for standard Treasuries. Both trailed Wall Street’s record run with the S&P 500 racking up a 19.4 percent increase, the strongest since 2013.

Much of TIPS’ gains stemmed from rising inflation expectations. TIPS yields or “real” yields, have held in a tight range since late September.

The 10-year TIPS yield was last at 0.55 percent on Wednesday, up over 3 basis points on the day.

DIFFERENT THIS TIME?

Since 2012, U.S. inflation has tended to pick up at the start of the year only to fade due primarily to a seasonal decline in oil prices.

The year-over-year increase on the Fed’s preferred inflation gauge, the core rate of personal consumption expenditure, has not topped 2 percent since February 2012. It was running at 1.5 percent in November.

The Consumer Price Index, which measures a broader basket of goods and services, ran at 2.2 percent on a year-over-year basis in November.

TIPS principal and interest payments are adjusted against the CPI.

The Labor Department will release its December CPI report at 8:30 a.m. (1330 GMT) on Friday. Analysts polled by Reuters forecast the CPI likely rose 0.2 percent in December for a year-over-year increase of 2.1 percent.

Even if CPI grows modestly, it would be enough to entice investors.

“TIPS look attractive as a form of insurance,” Western Asset’s Marki said. “The demand for TIPS will remain.”

Reporting by Richard Leong; Editing by Daniel Bases and Chizu Nomiyama

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