Mar 31, 2023
Inflation Traders See Scope for Fed Pause to Extend TIPS Gains
(Bloomberg) -- Investors are seeking protection for inflation that’s poised to stay higher for longer because they expect the Federal Reserve to abandon its fight for price stability prematurely to support the financial sector.
Rates traders are betting that banking-sector turmoil will lead the Fed to pause its year-long tightening campaign soon, with rate cuts to follow. It’s a backdrop that would potentially reignite inflation, which has spurred demand for Treasury Inflation-Protected Securities in the past couple weeks.
But bond traders know that approach has a time limit should tighter credit conditions in the wake of the banking chaos spur a severe economic slump. Recessions have typically crushed breakeven rates — closely watched market measures of inflation expectations that are derived from TIPS.
For now, some investors see a momentum play.
“We got bullish before the last Fed meeting as they can’t fight financial and price stability at the same time,” said Michael Sewell, portfolio manager at T. Rowe Price.
Like the rest of the bond market, inflation-linked Treasuries have done well of late. A TIPS index is primed for its best month since July, up about 2.4% through Wednesday, trimming the loss for the past year to 6.5%. That grim performance shows how a jump in real yields last year — a function in part of the Fed’s aggressive tightening — crushed the income to TIPS holders from higher inflation.
The 10-year breakeven rate briefly widened to 2.34% Friday after data showed the Fed’s preferred measure of inflation rose less than expected in February, to a 5% annual pace. The PCE deflator reached 7% last year.
Meantime, a survey of 12-month inflation expectations from the University of Michigan revealed a moderation to 3.6%, while a longer-dated indicator ticked up to 2.9%.
All told, the data and buying associated with month and quarter end helped spur bond gains, led by five-year Treasuries falling 9.5 basis points late in New York. The 10-year breakeven eased to 2.32% and has fluctuated between 2.1% and 2.6% since August, swinging within this range amid the extreme market volatility this month.
T. Rowe’s Sewell says 10-, and 30-year breakevens have scope to rise at least 20 basis points, although the trade may have limits given the brewing risk that bank stress causes a lending pullback.
“TIPS have proven to be a trading vehicle more than anything else,” said George Goncalves, head of US macro strategy at MUFG Securities Americas. “In many ways the TIPS market has been anticipating that inflation will come down and normalize, and lately the TIPS market has acknowledged that financial stability plays an important role in an economy that is highly leveraged.”
The big picture is that market expectations for inflation over the coming years remain well below current elevated measures of consumer prices. That suggests investors are confident that the Fed will succeed in its goal of establishing price stability, even if it comes at the cost of a recession. Some are flagging that prospect via the recent sharp contraction in US money supply.
If the past is any guide, in a recession the bond market may drive breakeven rates well below 2%, as seen in the early 2000s, 2008 and in 2020. Of course, traders would need to figure out whether a slump would truly extinguish the highest inflation pressure in four decades.
For all the history of recessions delivering a hammer blow of disinflation, rate cuts later this year, which the bond market now expects, could run the risk of the Fed repeating its mistakes from the 1970s, when it eased policy before inflation had been truly vanquished.
In commentary this week, BlackRock Investment Institute strategists including Wei Li wrote that “inflation is likely to prove even stickier than the Fed expects without a deep recession,” and the investment implication is one of being “overweight inflation-linked bonds on a tactical and strategic horizon.”
Markets Are Wrong on US Rate-Cut Bets, BlackRock Says
The challenge for the Fed will be getting inflation all the way back to its 2% target, said Roger Hallam, global head of rates at Vanguard Asset Management.
“There is a real question as to whether the Fed has the resolve to squeeze inflation from the system and it’s certainly an issue that the TIPS market will grapple with over the coming quarters,” he said.
Inflation News Bites
- Federal Reserve Governor Philip Jefferson said “it is going to take some time” to bring inflation back down.
- German inflation eased significantly, thanks largely to natural gas costs tumbling following their surge after Russia invaded Ukraine just over a year ago. Consumer prices in Europe’s biggest economy rose 7.8% in March compared with 9.3% in February. Spanish inflation also eased.
- The European Central Bank will need to increase interest rates further if recent tensions in the financial system stay contained, Chief Economist Philip Lane told Zeit in an interview.
- The British Retail Consortium said UK shop price inflation accelerated to 8.9% this month, a fresh peak for an index that started in 2005, and an increase from 8.4% in February.
- Bank of England Governor Andrew Bailey meanwhile said interest rates will probably remain below the highs seen before the financial crisis and policymaker Catherine Mann warned that underlyiung price pressures are “very sticky.”
Key Upcoming US Releases
- March 31: Personal income and spending report, include PCE, for February; University of Michigan report for March on inflation expectations (final)
- April 7: Monthly jobs report, including average wages data, for March
- April 12: Consumer price index report for March
- April 13: Producer Price Index for March
- April 14: Import and Export Price Indexes for March
- April 27: GDP report for first quarter (first reading)
- May 3: Federal Open Market Committee policy decision
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