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Bond Rally Intensifies Inflation Debate

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03/20/2017 | 11:20pm CEST
By Min Zeng 

A rise in U.S. government-bond prices since the Federal Reserve's latest rate increase underscores investors' continuing skepticism about inflation.

The yield on the 10-year Treasury note fell to 2.472% Monday, extending a decline since the Fed move on Wednesday, when yields were near their highest level in more than two years at 2.6%. Bond yields fall when prices rise.

Inflation has risen in recent months after spending years below the Fed's target, prompting many investors and analysts to search for signs of a breakout. Higher inflation chips reduces investors' real purchasing power, reducing the appeal of fixed-rate bond investments.

The U.S. economy is near the Fed's definition of full employment, and data in the U.S. and other developed economies say consumer prices are rising, increasing the pressure on central banks to pare stimulative policy.

Yet a survey-based gauge of U.S. consumer inflation expectations over the next five to 10 years hit a record low this month, according to a release from University of Michigan on Friday, and some market-based measures show little change in recent months.

The debate underscores the uncertainty over the prospects for U.S. growth and asset prices in coming years. Long-term rates have risen since Donald Trump's election as president, reflecting expectations the administration will boost fiscal spending and cut taxes, but many investors question the pace at which his economic-policy proposals might take effect.

"The reflation story may not be a long-lasting one," said Lynn Chen, senior portfolio manager at Aberdeen Asset Management.

Many market-based inflation readings highlight this skepticism. The 10-year break-even rate, which measures the yield premium on the 10-year Treasury note relative to comparable Treasury inflation-protected securities, was 2.01 percentage points Monday. That reflects investors' expectation of an annual 2.01% rate of inflation over the next 10 years, nearly the same as the 2% reading on the five-year break-even rate.

The 10-year break-even rate should be higher than the five-year rate if investors expect inflation to flare up, say some investors.

The Fed raised rates last week for a third time since the financial crisis and signaled a gradual pace in tightening policy amid tentative signs of a shift away from a prolonged period of weak growth and low inflation.

David Rosenberg, chief economist and strategist at Gluskin Sheff & Associates Inc., said there has been a 73% correlation between inflation expectation data from University of Michigan and the 10-year Treasury yield. That means the two variables move in tandem 73% of the time.

Federal Reserve Bank of Minneapolis President Neel Kashkari, the only member of the Fed's policy committee to dissent from last week's rate increase, cited inflation as a key reason for his vote in a Friday statement.

"Inflation is still below our target," he wrote. "While there are some signs of inflation slowly building toward our target, it isn't happening rapidly, and inflation expectations appear well-anchored."

U.S. consumer prices rose by an annualized pace of 2.7% in February, well above the Fed's 2% target. Yet the Fed's preferred inflation gauge -- the personal-consumption expenditures price index -- has risen at a more subdued pace. The PCE was up 1.9% over the past 12 months in January. Excluding energy and food, the so-called core PCE was up 1.7%.

Some investors say the upticks in inflation are a sign of a brighter growth outlook.

Demand for TIPS has been robust, reflecting growing appetite from investors for inflation protection. TIPS holders get extra payments when inflation rises above certain thresholds. U.S. mutual bond funds and exchange-traded funds targeting TIPS attracted a net $246 million new cash for the week that ended March 15, bringing the year-to-date total to $5.3 billion, according to data from fund tracker Lipper.

A slow rise in inflation benefits the economy because it boosts the prospect of higher compensation for workers, increases tax revenue for the federal government and reduces the real burden of debt payments. Some see the rise as a normalization of inflation, making it easier for major central banks to fulfill their inflation mandate.

This environment has been emboldening investors to chase riskier assets for better return. U.S. stocks trade near record highs and emerging market stocks and bonds have also attracted robust demand this year.

"We welcome inflation returning toward trend particularly given the low level of productivity and wages," said Gemma Wright-Casparius, senior portfolio manager of the fixed-income group at the Vanguard Group.

Deepa Majmudar, money manager at J.P. Morgan Asset Management, cautions that investors may underestimate the risk of long-term inflation.

"Many have been so used to low inflation over the past decades," so they may be caught off guard by "an inflation shock," she said.

Write to Min Zeng at min.zeng@wsj.com

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