U.S. inflation bonds gain appeal on oil, rising wages

* TIPS funds rack up biggest weekly inflows in 1-1/2 years

* Rising wages seen boosting U.S. inflation in coming months

* OPEC poses downside risk if it fails to reach output deal

NEW YORK, Nov 7 (Reuters) - Investors are making their biggest bets in years that inflation is coming out of its slumber, pouring money into a corner of the U.S. bond market in response to a rebound in oil prices and nascent signs of rising wages.

Growing demand for the $1.2 trillion U.S. Treasury Inflation Protected Securities sector is also underpinned by remarks from Federal Reserve Chair Janet Yellen in October on managing a “high-pressure economy,” which gave rise to the view the U.S. central bank would allow inflation to run above its 2 percent target.

“I think it’s feeding the narrative of a backdrop that one should own inflation protection,” said Martin Hegarty, head of inflation-linked bond portfolios at BlackRock Inc in New York.

Money has flowed into TIPS funds after Yellen’s comments on Oct. 14. Inflows of $723.7 million in the week ended on Nov. 2 were the biggest since they hit $1.39 billion in April 2015, according to Thomson Reuters’ Lipper unit.

TIPS funds are on track for their biggest year of inflows since 2011, when they pulled in $9.7 billion.

Break-even rates for TIPS, the differences between yields from those bonds and regular Treasuries, have recovered along with stocks and other growth-oriented investments. This gauge of investors’ U.S. inflation expectations had plunged after Britain’s surprise vote to leave the European Union in June.

Last week, the 10-year TIPS break-even rate touched its highest level since July 2015 at 1.75 percent. The rise came even as U.S. oil futures scaled back from 15-month highs reached in October because of bets that the Organization of the Petroleum Exporting Countries would strike a deal to reduce output.

The U.S. Consumer Price Index, which TIPS principal and interest payments are adjusted against, rose 1.5 percent in September from a year earlier, the highest since October 2014.

The rebound in CPI and inflation expectations has also bolstered TIPS’ total return, outpacing nominal Treasuries and most other U.S. high-grade bonds.

Year-to-date, TIPS have returned 6.92 percent, more than the 4.14 percent on regular Treasuries and 5.09 percent on all investment-grade debt, according to indexes compiled by Bloomberg/Barclays.

Still, the CPI and TIPS break-even rates are stuck below the Federal Reserve’s 2 percent inflation goal, despite their recent upswing, as global demand remains sluggish.

“We are not expecting a big surge in inflation,” said Alex Roever, head of U.S. interest rate strategy at J.P. Morgan Securities in New York. “As disinflationary pressures fade away, inflation expectations will start to build.”


A hopeful sign for Fed policymakers was the 2.8 percent year-over-year pickup in average hourly earnings in October, the highest since June 2009.

This suggested a tightening labor market may finally be pushing up wages and providing the foundation for inflation to climb further in the coming months.

“When you see average hourly earnings, it supports the idea the inflation is coming back,” Roever said.

If OPEC fails to clinch a production agreement on Nov. 30, there may be a sell-off in the energy market, which has been supported by bets that such a deal would reduce a global glut.

The resulting drop in oil prices would curb the CPI’s uptrend and would diminish TIPS’ appeal.

“The OPEC issue is a short-term risk,” BlackRock’s Hegarty said.

Nevertheless, he said, traders are underpricing inflation risk in the coming months by as much as 1 percentage point from current levels if oil and wage trends hold.

“The level of inflation priced into the market,” he said, “is still incredibly, incredibly low to the expected outcome of CPI.”

Reporting by Richard Leong; Editing by Lisa Von Ahn