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U.S. inflation-linked bonds roiled, pose dilemma for Fed

By Karen Brettell

NEW YORK (Reuters) - U.S. inflation-linked government bonds have tumbled to levels that analysts say approach those common in periods of financial crisis, a sharp turnaround for what has been one of the best-performing bond classes in recent years.

Bond markets around the world have been rocked by the shift in thinking from the U.S. Federal Reserve, which Fed chairman Ben Bernanke made clear last week when he said the U.S. central bank may start paring bond purchases later in the year.

But the relative illiquidity of Treasuries Inflation-Protected Securities and the large number of long positions in that market made the rout in these securities even worse as investors headed for the exits. TIPS have been strong performers in recent years as investors sought protection on the expectation that bond purchases would increase inflation.

That hasn't happened, however, and the bonds dramatically worsened after Bernanke downplayed concerns about low inflation, stating that he expects price pressures to rise back to the Fed's targets. Bernanke focused instead on the improving economy and falling unemployment rate.

"The market is unprotected, where it thought it had a little bit of protection in the form of the Fed," said Aaron Kohli, an interest rates strategist at BNP Paribas in New York. "It's showing you that there is a good risk of financial stress, that there are liquidity concerns ahead."

Many TIPS funds have been left smarting from the turmoil. The two worst-performing fixed income funds year-to-date are TIPS funds, according to Lipper, a Thomson Reuters company.

The DFA Dimensional Retirement Fixed Income Fund, with $2.1 million in assets, is down 23.1 percent on the year while the $350 million Pimco Real Return Asset Fund has lost 16.4 percent, Lipper data show.

Inflation measures have tumbled and are well below the Fed's long-term target of around 2 percent. Personal Consumption Expenditures (PCE) fell to a record low 1.05 percent on the year in April, the most recent data available. The Consumer Price Index (CPI) is running at 1.4 percent.

For investors in TIPS and other inflation products, Bernanke's comments came as a shock, as they expected purchases would continue until inflation was rising at the upper end of Fed targets. It is also leaving them flummoxed over what the impetus for rising prices will be without Fed stimulus in an improving but still lackluster economic recovery.

"The raw fuel for inflation is there, but it doesn't necessarily mean that it gets a spark to ignite it," said Stewart Taylor, co-portfolio manager of the Eaton Vance Short Term Real Return Fund in Boston, which invests in short-dated TIPS. That fund is down 1.7 percent this year.

Inflation expectations as measured by TIPS bonds have plunged, with 10-year levels dropping below the key 2 percent level that in the past has been associated with more Fed stimulus, not less. It hit a low of 1.80 percent on Monday before rising to about 1.96 percent on Tuesday. If the low levels persist, it may complicate the Fed's ability to exit from its bond-buying strategy.

The rate has only dropped below 2 percent two other times since the failure of Lehman Brothers in 2008 sparked a deflationary shock that initiated the Fed's unconventional policy. In each case - in late 2010 and 2011 - the Fed responded with new rounds of bond purchases, or quantitative easing, that sent inflation expectations back above the 2 percent level.

"In the last 10 years we haven't been below this level of inflation for a very long period of time, it should be concerning the Fed right now. All of the latest round of QE has been undone in a matter of weeks," Kohli said.

Analysts note that moves have been exacerbated by illiquidity, as TIPS represent only around 10 percent of outstanding U.S. government debt.

Pension funds, hedge funds and other institutional investors that bought TIPS in expectation of higher inflation headed to the exits at the same time, while banks that have been shrinking their balance sheets have been less able to absorb the selling.

"It's a one-sided market and everyone is looking for bids," said Richard Gilhooly, an interest rate strategist at TD Securities in New York.

The sell-off also reflects the high premium that TIPS bonds have afforded over the past few years, where investors accepted negative yields, after accounting for inflation, expecting that the lost returns would be made up for by rising inflation.

TIPS principal increases when consumer prices rise. Based on the rise in principal, the interest paid also increases. Falling inflation expectations makes these bonds less attractive.

The sell-off may be creating opportunities in shorter-dated TIPS as investors have begun pricing in lower inflation than may be likely in the near-term. Two-year TIPS breakevens, for example, have dropped to 87 basis points, said Taylor.

"If over the next two years you think inflation will be north of 1 percent, you are much better off with a two-year TIPS than a two-year Treasury," said Taylor.

(Editing by Kenneth Barry)

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