As the Federal Reserve moves closer to the bond market’s outlook on interest rates, the market has moved closer to the Fed’s view on inflation.
That’s a boon for Pacific Investment Management Co., which renewed its call for investors to guard against rising inflation shortly before the Fed’s policy announcement on Wednesday. With officials paring their forecasts for interest-rate increases and core consumer-price data exceeding analyst estimates, it turned out to be the best day in a year for a bond-market measure of expected inflation, reviving hopes for a trade that’s been a loser for three years.
Wagers on Treasury Inflation-Protected Securities had gone against investors from Pimco to Goldman Sachs to Brown Brothers Harriman amid tepid price and wage growth and as commodities plunged. The last time the bond market’s inflation expectations were aligned with the Fed’s 2 percent target was in August 2014. Fed Chair Janet Yellen said inflation “is expected to gradually move back” to the central bank’s goal after policy makers on Wednesday pared their forecasts for 2016 interest-rate increases to two from four in December.
"Markets are not fully priced for this reflation idea," said Anthony Crescenzi, market strategist at Pimco, in a radio interview with Tom Keene on Bloomberg Surveillance before the Fed meeting concluded. Inflation-indexed securities "are a good buy here."
The gap between yields on nominal five-year notes and equivalent-maturity TIPS, a gauge of expectations for consumer-price growth known as the five-year break-even rate, surged on Wednesday by the most in a year and now shows a 1.48 percent projected annual inflation rate over the next half decade. That metric plunged last month to the lowest since 2009 as a collapse in oil prices and an equity-market rout stoked concern that global growth is slowing.
Inflation-linked bonds have lagged behind the broader market in each of the past three years. TIPS have returned 1.8 percent this year, while conventional Treasuries gained2.15 percent, based on Bank of America Merrill Lynch indexes.
Goldman Sachs said in November that 2016 will be a “reflationary year” in the U.S., only to see the recommendation quickly go awry as oil tumbled. Goldman had recommended betting that the 10-year U.S. break-even rate would rise. The company abandoned the call Jan. 15 and said wouldn’t re-initiate it at that point.
Consumer prices in the U.S., excluding food and fuel, climbed more than forecast in February for a second month, figures from the Labor Department showed Wednesday in Washington. The core CPI measure, which excludes volatile food and fuel costs, rose 2.3 percent from February 2015, the most since May 2012, after rising 2.2 percent in the prior 12-month period.
The Fed’s preferred gauge of inflation, which is the Commerce Department’s personal consumption expenditures measure, hasn’t matched the central bank’s 2 percent goal since April 2012.
Oil prices have rallied 48 percent since Feb. 11 after plunging to the lowest in 12 years.
"Near term there are still concerns about inflation or the lack thereof, but I think clearly over the longer term these expectations are too low,” said Brian Rehling, chief fixed- income strategist at Wells Fargo Advisors, which upgraded TIPS to favorable in January. “If you think of the impact of energy on inflation, which can be meaningful, that continues to provide upward pressure over the long run. I think that’s really a factor in what the market’s thinking about and trading on now."
While Pimco has said the market was overreacting to the drop in oil prices and that inflation would resurface, traders have remained skeptical a robust jobs market will translate into wage and price gains in the near term, even as the longer-term outlook improves.
“Given the upside print in CPI and the dovish Fed outlook, we continue to favor long-end break-evens,” Morgan Stanley economists and strategists led by Ellen Zentner wrote on Wednesday. Still, they were more skeptical about near-term moves in the Fed’s preferred gauge, saying they believe “core PCE topped out in January and will move lower into the summer.”
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