Bloomberg News

Treasury Two-Year Break-Even Rate Distorted by Twist, Pond Says

October 03, 2011

Oct. 3 (Bloomberg) -- The Federal Reserve’s plan to sell shorter-term inflation-indexed debt and buy longer-term securities is distorting a gauge of inflation, according to Barclays Plc’s Michael Pond.

The difference in yield between two-year notes and Treasury Inflation Protected Securities, a gauge of inflation over the life of the debt known as the break-even rate, has narrowed to 1.03 percentage points from 1.40 percentage points on Sept. 21, when the Fed announced the program known as Operation Twist. The 10-year break-even rate has narrowed to 1.74 percentage points from 1.86 percentage points during the same period.

“The Fed is distorting the shorter-dated break-evens and thus distorting inflation expectations there,” Pond, co-head of interest-rate strategy at Barclays in New York, said in a phone interview. “If Fed officials mistake lower break-evens for lower inflation expectations, it may lead to additional stimulus, which would be a policy mistake.” As one of the 20 primary dealers, Barclays trades with the Fed.

The central bank plans to buy $1 billion to $1.5 billion of TIPS maturing from January 2018 to February 2041 on Oct. 5 and sell the same amount of inflation-indexed debt due from April 2012 to July 2014 on Oct. 17.

The Fed bought today $2.5 billion of nominal Treasuries maturing between February 2036 and August 2041 in the first operation of its replacement of $400 billion of shorter-term nominal debt and TIPS in its portfolio with longer-term securities to reduce borrowing costs.

Bullard on Inflation

St. Louis Fed President James Bullard said last week in San Diego that the central bank is prepared to ease policy should the U.S. economy weaken, while watching inflation risks.

“Outright asset purchases are a potent tool and must be employed carefully,” said Bullard, citing the increase in inflation and inflation expectations during the past year. The central bank “still has to judge tradeoffs between inflation and support for the recovery,” he said.

Holders of TIPS receive an adjustment to the principal value of their securities equal to the change in the consumer price index, in addition to a fixed rate of interest that’s smaller than the interest paid to a holder of conventional debt. The difference is known as the break-even rate.

The annual inflation rate in 2011 will be 3 percent, according to the median forecast of 63 economists in a Bloomberg News survey.

The central bank purchased $2.3 trillion in debt in two rounds of what is known as quantitative easing to keep borrowing costs for companies and consumers low. The target rate for overnight lending between banks has stayed at a record low zero to 0.25 percent since December 2008.

--Editors: Dennis Fitzgerald, Paul Cox

To contact the reporter on this story: Cordell Eddings in New York at ceddings@bloomberg.net

To contact the editor responsible for this story: Dave Liedtka at dliedtka@bloomberg.net


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