Bloomberg News (BN) Date: Dec 16 2013 7:29:17
TIPS Wipeout Signals Fed Losing Fight Against Disinflation (1)
By Susanne Walker and Daniel Kruger
Dec. 16 (Bloomberg) -- Bond investors are signaling they
expect the Federal Reserve to lose its battle against
disinflation, even after inundating the U.S. economy with more
than $3 trillion in the past five years.
While central banks around the world are trying to spur
demand and boost prices, signs are emerging that a slowdown in
inflation is becoming entrenched. Treasury Inflation-Protected
Securities are suffering unprecedented losses after inflation in
the U.S. rose 1 percent last month, the smallest increase since
2009. Known as TIPS, the bonds have plunged 8.8 percent this
year, the most since they were introduced in 1997, according to
Bank of America Merrill Lynch indexes.
“The idea that central banks can always get the inflation
rate they want is something that’s going to pass away,” Peter
Fisher, the former Fed official and undersecretary for domestic
finance at the U.S. Treasury, who now serves as senior managing
director at BlackRock Inc., said in an interview on Dec. 9. “We
could be at a 1 percent inflation rate for a long time.”
Losses on TIPS accelerated in the past month, wiping out
returns in September and October, after Fed Vice Chairman Janet
Yellen became the favorite to succeed Chairman Ben S. Bernanke.
While Yellen has voted for every stimulus measure since 2008 and
drawn criticism from some lawmakers concerned that her approach
will spur too much inflation, a slowdown in price increases may
pose a more imminent threat to the economy by causing consumers
and businesses to put off spending.
Wishful Thinking
Companies in the U.S. are already finding ways to expand
without hiring more workers and wages are mired in the weakest
period of growth in at least five decades.
“It’s hard for me to see accelerating inflationary
pressures unless we get some pick-up in wage expectations,”
said Fisher at New York-based BlackRock, which oversees $4.1
trillion as the world’s largest asset manager.
After dropping its benchmark interest rate close to zero
percent in 2008, the Fed began buying bonds with the aim of
stimulating growth in an economy devastated by the worst
financial crisis since the Great Depression.
While the Fed has flooded the economy with dollars to
promote growth, swelling its assets to almost $4 trillion from
$900 billion in 2008, investors in inflation-linked bonds are
losing confidence in the bank’s ability to spur prices.
TIPS had staged their biggest rally of the year in
September and October with a 2.2 percent advance as Yellen, one
of the main architects of the Fed’s easy-money policies, emerged
as the candidate to lead the central bank once Bernanke’s term
expires on Jan. 31.
Short-Lived
Nominated by President Barack Obama on Oct. 9, Yellen told
Congress on Nov. 14 that maintaining price stability was key to
the Fed in its support of the economy.
Those gains have since evaporated. The 2.2 percent loss
since the end of October was almost double the slump for all of
2008, the only other year that the securities fell, index data
compiled by Bank of America show.
The 10 largest inflation-indexed mutual funds, including
those from Vanguard Inc., Pacific Investment Management Co. and
BlackRock, have lost 36 percent of their assets since the start
of May, shrinking to $62.7 billion by the end of November,
according to data compiled by Morningstar Inc.
“When inflation is falling or extremely low, TIPS are not
a great investment vehicle,” Gary Pollack, the New York-based
head of fixed-income trading at Deutsche Bank AG’s private
wealth management unit, which oversees $12 billion, said in a
Dec. 11 telephone interview. “I’m avoiding TIPS. I don’t see
inflation becoming an issue over the next three to six months.”
Mispriced Risk
The gap between yields on TIPS and fixed-rate Treasuries
show that traders anticipate inflation will average 1.75 percent
in the next five years. That’s plummeted from this year’s high
of 2.42 percent in March.
Cost-of-living increases will average 1.5 percent this
year, according to economists surveyed by Bloomberg, the least
since prices fell in 2009 and the second-lowest reading since
1963. Consumer prices rose by 1 percent in October from a year
earlier. The rate compares with a three-year high of 3.9 percent
in September 2011.
William Irving, a fixed-income manager at Fidelity
Investments, which oversees $1.8 trillion, said inflation will
probably accelerate over time as the Fed’s purchases of $85
billion of debt each month spurs more growth, indicating that
TIPS are attractive after the rout.
U.S. economy expanded at an annual rate of 3.6 percent in
the third quarter, the strongest pace since the first quarter of
2012, a government report on Dec. 5 showed.
No Jobs
“The market right now is not pricing in any risk premium
for inflation,” he said in a telephone interview on Dec. 12.
“Given the fact that the Fed is so accommodative and probably
would like inflation to be higher rather than lower, it’s
probably not a bad time to own 10-year TIPS.”
Yields on the benchmark 10-year TIPS fell two basis points,
or 0.02 percentage point, to 0.67 percent as of 8:27 a.m. New
York time, according to Bloomberg Bond Trader prices. The 0.375
percent inflation-linked note due in July 2023 rose 5/32, or
$1.56 per $1,000 face value, to 97 9/32.
U.S. companies may be undermining the Fed’s strategy of
suppressing borrowing costs to encourage investment. Instead of
adding more people or machinery, companies increased spending on
software by 19 percent since the 2007 business-cycle peak,
according to the Bureau of Economic Analysis.
That’s one reason why it’s taken more than four years since
the end of the recession to bring the nation’s jobless rate down
to 7 percent from 10 percent in 2009, which was the highest in
26 years.
Black Friday
The lack of wage growth will probably damp consumer
spending and keep retailers from raising prices, according to
Dan Heckman, a fixed-income strategist at U.S. Bank Wealth
Management, a unit of U.S. Bancorp that oversees $112 billion.
Average hourly earnings rose 2.2 percent in October, less
than the two-decade average of 3.1 percent, according to Labor
Department data. Wages have increased less than 3 percent in
every month since June 2009, the longest stretch since the
government began releasing the data in 1965.
U.S. retailers suffered the first spending drop on a Black
Friday weekend since 2009, increasing the likelihood companies
from Wal-Mart Stores Inc. and Target Corp. will extend the deep
discounts that’s already hurting their profit margins.
“It’s very difficult to get any kind of wage increases,”
Heckman said in a telephone interview on Dec. 9. “Consequently,
we don’t see any kind of inflation pressure.”
Heckman said his firm is avoiding TIPS.
Global Phenomenon
Disinflation may also be harder to overcome in the U.S. as
price gains weaken around the world, depressing export demand
and making imported goods less expensive.
European Central Bank President Mario Draghi said on Nov. 7
that the region faced the prospect of a “prolonged” period of
low inflation in explaining the ECB’s decision to cut its
benchmark rate by half to 0.25 percent.
Three weeks later, the European Union statistics office
said consumer prices for the 17 nations that share the euro rose
0.9 percent in November from a year earlier, less than the ECB’s
goal of “close to but below” 2 percent. As recently as
November 2011, euro-zone inflation was 3 percent.
While the ECB, the Bank of Japan and Bank of England have
all committed to programs to cut borrowing costs and spur
inflation, consumer prices globally will rise 2.31 percent this
year, data compiled by Bloomberg show. That would be the least
since 2009 and the third straight year inflation has slowed.
First Loss
Inflation-linked bonds globally have fallen 4.4 percent and
are poised for the first annual loss on record, according to
Bank of America index data.
“There was a notion out there with all these reserves
being created, with all this money being printed that sooner or
later there has to be an inflationary impact,” said Mitchell
Stapley, the Grand Rapids, Michigan-based chief investment
officer at ClearArc Capital Inc., which manages $15 billion.
“Today, there is just not the concern about the inflationary
backdrop that you need to have to drive demand” for TIPS.
Stapley said ClearArc, the asset-management arm of Fifth
Third Bank, has reduced the amount of TIPS that its bond funds
hold by about 80 percent.
Smaller price increases have fixed-rate U.S. government
bonds more attractive relative to TIPS. After adjusting for
inflation, yields on 10-year Treasuries reached 1.91 percent
this month, the highest since February 2011. The nominal yield
on the 10-year note was at 2.85 percent today.
Dollar Strength
The dollar is forecast to strengthen against all nine
other Group-of-10 currencies next year, extending the best
annual gain since 2008. The dollar will appreciate 4.4 percent
versus the yen and 6.9 percent against the euro in 2014,
according to data compiled by Bloomberg.
The gains may bolster demand from foreigners who own about
50 percent of U.S. government’s debt obligations and temper any
selloff when the Fed tapers. Their purchases of Treasuries have
helped financed deficits as increased government spending since
the credit crisis more than doubled the amount of U.S. debt
outstanding to a record $11.8 trillion.
The Fed will probably start curtailing its own purchases at
its two-day meeting starting tomorrow, according to 34 percent
of economists surveyed Dec. 6 by Bloomberg, an increase from 17
percent in a Nov. 8 survey. Forty percent of the 35 economists
surveyed predict tapering in March.
Disinflation in the U.S. has confounded the predictions of
a group of economists and investors who signed a letter warning
Bernanke on Nov. 15, 2010, that the Fed’s quantitative easing
would fuel inflation and cause the dollar to depreciate.
Reality Check
The 23 people included John Taylor, the Stanford University
professor and former undersecretary of Treasury for
international affairs, and Clifford S. Asness, head of AQR
Capital Management LLC, the Greenwich, Connecticut-based hedge
fund that oversees about $79 billion.
For Wan-Chong Kung, who oversees $325 million of inflation-
linked securities at Nuveen Asset Management in Minneapolis, the
temporary jump in inflation expectations as Yellen became the
favorite to lead the Fed demonstrates the danger of anticipating
price gains before they actually emerge.
After avoiding TIPS for a year, Kung began buying in
September. She has since pared those stakes and returned to
being skeptical of their value.
“Investors need to see the reality of inflation instead of
just the potential for it,” Kung said in a Dec. 11 telephone
interview.
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“I have not failed. I've just found 10,000 ways that won't work.” ~ Thomas Alva Edison
John Broussard
Assistant State Treasurer
Chief Investment Officer
State of Louisiana
Department of the Treasury
225-342-0013
jbroussard@treasury.state.la.us
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