History is repeating itself in the bond market as investors capitulate on bets that the Federal Reserve’s money-printing efforts will spark faster inflation.
Firms from U.S. Bancorp to Federated Investments that had been buying government securities that protect against rising consumer prices during the Fed’s recent efforts to inject cash into the economy are now selling on the behalf of clients. For the first time since the depths of the financial crisis in 2008, mutual funds that target Treasury Inflation-Protected Securities have seen outflows for three straight months, according to Morningstar Inc. (MORN:US)
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Even after the Fed injected more than $2.3 trillion into the financial system since 2008, inflation is under control, bolstering the appeal of bonds while providing the central bank with more scope to provide stimulus as needed to foster the economic recovery. Commodity prices are down and wages have grown just 1.9 percent on average since 2009, below the 3.1 percent in the prior three years, government data show.
“With such weak labor markets, flat income growth and flat wages, and commodities weak, we just won’t see the inflation that the TIPS market is pricing in,” Dan Heckman, a fixed- income strategist at the U.S. Bank Wealth Management unit of U.S. Bancorp, which manages $110 billion, said in telephone interview April 9.
After buying TIPS through December, the Minneapolis-based firm has been selling the securities. TIPS have suffered a sell- off during each of the past five years even though the Fed has pumped more than $2.5 trillion into the economy through its bond purchase programs in a policy known as quantitative easing.
“We’ve been told to expect inflation every year for the last four years and it hasn’t happened,” James Kochan, chief fixed-income strategist at Wells Fargo Funds Management LLC in Menomonee Falls, Wisconsin, said in an April 10 telephone interview. “I’m not a big believer that you have to buy inflation protection here.” Kochan said he has been advising investors to sell TIPS.
Current yields on such bonds due in five years mean investors would only profit if the consumer price index rises more than 2.18 percent annually. The principal on inflation- linked debt rises in tandem with the increase in the CPI.
The gauge will increase 1.9 percent this year and 2.1 percent in 2014, according to the median forecast of 74 economists in a Bloomberg survey. The median forecast is for a 2.2 percent rise in 2015.
“Realized inflation has actually been coming down over the last 12 to 15 months,” said Donald Ellenberger, who oversees about $10 billion as co-head of government and mortgage-backed securities at Federated Investors in Pittsburgh. Ellenberger said in a March 28 phone interview he sold short-term TIPS.
A Fed index measuring inflation expectations, the five- year, five-year forward break-even rate, fell to 2.69 percent last week from a 17-month high of 2.89 percent in January.
That’s the lowest level since before the central bank said in December it would buy $45 billion of Treasuries a month on top of the $40 billion of mortgages it was already purchasing.
Yields on TIPS have fallen below zero percent as interest rates for non-indexed debt dropped to historic lows. Investors are willing to accept negative yields because the face value rises along with the consumer price index.
Current five-year TIPS yields rose nine basis points, or 0.09 percentage point, to negative 1.65 percent. The price of the 0.125 percent security fell 13/32, or $4.06 per $1,000 face amount, to 107 12/32. The Treasury will auction $18 billion of five-year TIPS on April 18.
TIPS “have cheapened for a reason as weaker economic data has led to somewhat of a sell-off in break-evens,” Michael Pond, head of global inflation-linked research in New York at Barclays Plc, one of 21 primary dealers that trade with the Fed, said in an April 10 telephone interview. “And that could continue given the economic data and performance of commodities.”
Yields on five-year Treasuries not indexed to inflation were little changed last week at 0.69 percent, according to Bloomberg Bond Trader data. Treasury 10-year (USGG10YR) note yields declined two basis points, or 0.02 percentage point, to 1.70 percent as of 1:04 p.m. in New York.
The International Monetary Fund cut its forecast for U.S. economic growth last week as automatic budget cuts slow the expansion, according to a draft of the Washington-based lender’s World Economic Outlook. Gross domestic product will expand 1.7 percent this year, down from a previous forecast of 2 percent, according to the report obtained by Bloomberg News. The draft may be revised before its scheduled April 16 release.
The Goldman Sachs Standard & Poor’s Commodity Index (GI1) has declined 8.4 percent since the end of August.
The cost of insuring against inflation during the next five years is still relatively expensive. At 2.18 percentage points, the break-even rate on five-year TIPS compares with 2.47 percentage points on 30-year TIPS.
The spread, which is below the median of 0.62 the past five years, shrank to about 0.15 percentage point in March. The last time the gap was that narrow was in July 2008, when oil reached a record $147.27 a barrel and the consumer price index was rising at a 5.6 percent clip. Oil closed at $91.29 last week. It was $88.91 today.
Led by the Fed’s more than $2.5 trillion since 2008, central banks around the world have injected about $5.3 trillion into the economies to sustain growth. All that extra cash is bound to eventually spark inflation, according to Bill Gross, manager of Pacific Investment Management Co.’s $289 billion Total Return (PTTRX) Bond Fund, the world’s largest.
“We’re not inflationary hawks in 2013,” Gross said in a Feb. 22 interview with Bloomberg. “We simply think because central banks are writing trillions of dollars worth of checks, ultimately that will produce the desired inflation they are targeting.”
Returns on TIPS have topped non-indexed Treasuries since 2009, gaining an average of 9.4 percent in each of the past four years, versus 3.41 percent for nominal U.S. government debt, according to Bank of America Merrill Lynch indexes. This year, nominals are beating TIPS, 1.93 percent versus 1.27 percent.
“Buy insurance when it’s cheap,” Mitchell Stapley, the Grand Rapids, Michigan-based chief fixed-income officer for Fifth Third Asset Management, which oversees $15 billion in assets, said in an April 10 telephone interview. “It’s not like you’ve suffered long periods of underperformance” by owning inflation-indexed U.S. debt versus nominal Treasuries.
Investors have withdrawn $2.8 billion in the first three months of 2013 from mutual funds that the buy TIPS, the longest period of withdrawals since the fourth quarter of 2008, according to Chicago-based fund tracker Morningstar.
Exchange-traded funds that invest in the debt has outflows in January and February, the first two-month period since at least 2003 when investments in both ETFs and mutual funds fell.
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An employment rate above 7 percent makes it hard to generate inflation, according to Michael Materasso, a senior portfolio manager and co-chairman of the fixed-income policy committee at Franklin Templeton Investments in New York.
Payrolls in March grew by 88,000, the least in nine months and less than the most-pessimistic forecast in a Bloomberg survey, according to Labor Department data released April 5. The share of the working-age population in the labor force, known as the labor force participation rate, fell to 63.3 percent, the lowest since May 1979.
“It will take a while for the consumer to generate enough income which then could put pressure on prices from a demand perspective,” Materasso, whose firm oversees about $394 billion, said in an April 10 telephone interview. Inflation “is not an immediate concern,” Materasso said.
The firm recently sold TIPS, though he declined to specify when or in which portfolios.
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