Monday, December 16, 2013

It's The Economy Stupid: Fed Losing Battle Against Disinflation

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.




     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




“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



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