Investors bet U.S. inflation is near
(FT) -- Investors are betting that an aggressive push by the Federal Reserve to revive the US economy could drive up inflation, with Treasury bond markets pricing in the effects of a return to emergency monetary easing next month.
Inflation expectations in the US have jumped sharply this week, with one measure rising to its highest level since late June. So-called breakeven inflation rates, which are the bond market's expectations of future inflation levels, have leapt on the growing belief that the Fed will initiate a fresh round of quantitative easing -- in effect, pumping money into the economy -- at the November meeting of its interest rate-setting committee.
Breakeven rates reflect the difference between yields on cash Treasury bonds and those of Treasury inflation-protected securities, or Tips.
The 10-year breakeven rate rose as high as 1.98 per cent on Wednesday, its highest level since June 24. It is up from 1.8 per cent on Monday and well above its low for the year of 1.51 per cent in late August. By the close in New York on Thursday it had slipped back to 1.91 per cent.
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The yield on the 30-year bond above that of the 10-year note has also hit a record at 1.31 per cent, up from 1.16 in September.
As stocks tumbled over the summer, many investors feared the US could suffer a prolonged bout of Japanese-style deflation. The Fed's message that it is determined to avoid this has led to the recalibration of inflation expectations.
"The price action is telling you that QE is coming and that the Fed will deliver it," said George Goncalves, head of interest rate strategy at Nomura Securities.
However, Richard Fisher, Dallas Fed president, sought to damp expectations, saying on Thursday: "The markets have drawn too quick a conclusion that this [easing] is a likely event," Reuters reported.
"If the Fed is successful with QE, inflation breakevens should be higher," he said.
The dollar on Thursday tumbled to a fresh 15-year low against the yen and hit its lowest level in 8 months against sterling. The Australian dollar rose to its highest against the US currency since it was floated in 1983.
While breakeven rates remain well below their highs of earlier this year -- the 10-year rose to 2.47 per cent in January -- the prospect of renewed QE and the Fed's desire to push inflation higher poses a significant risk to bond market investors.
Also under pressure is the dollar, which has fallen to successive 15-year lows against the Japanese yen and shed 5 per cent versus the euro since the Fed's meeting in September.
The yield on 30-year Treasury bonds, which are highly influenced by inflation expectations, has climbed to a record high and is 1.3 percentage points over the 10-year note yield. A rise in inflation would erode real returns on government debt, making Treasuries less attractive to hold. That could lead to a bond sell-off.
"Breakeven inflation rates should rise significantly from their present levels, particularly as Fed officials are talking about allowing inflation to rise above their target level for a period of time," said Michael Pond, co-head of US rates strategy at Barclays Capital.
This week officials including William Dudley of the New York Fed and Charles Evans of the Chicago Fed have supported tolerating a period of inflation above the central bank's target so as to offset times when inflation is below target. "Markets are just not priced for that outcome," said Mr Pond.
That has compelled investors to buy equities, commodities and government bonds, while shunning the dollar. While 10-year breakeven rates rose above 1.90 per cent after the Fed's September meeting, until this week, inflation expectations had been contained.