TIPS Wipeout Signals Fed Losing Fight Against Disinflation
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 consumer prices 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.
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.
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.”
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.
“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 one basis point, or 0.01 percentage point, to 0.66 percent as of 12:15 p.m. New York time, according to Bloomberg Bond Trader prices. The 0.375 percent inflation-linked note due in July 2023 rose 1/8, or $1.25 per $1,000 face value, to 97 3/8.
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 has taken more than four years since the end of the recession to bring the nation’s unemployment rate down to 7 percent from 10 percent in 2009, which was the highest in 26 years.
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.
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.
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 (USGG10YR) 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.
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.
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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