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Morgan Stanley sees inflation risk as Fed sends TIPS yields down

Monday, March 23, 2015 - 19:41
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Morgan Stanley is advising clients to bet on a revival in US consumer prices, predicting the Federal Reserve will refrain from tightening policy until 2016.

[TOKYO] Morgan Stanley is advising clients to bet on a revival in US consumer prices, predicting the Federal Reserve will refrain from tightening policy until 2016.

Yields on 10-year Treasury Inflation-Protected Securities, or TIPS, fell as low as 0.125 per cent on Monday, the least since Feb. 6, after the Fed indicated last week it isn't in a rush to raise borrowing costs, leaving the door open for economic growth to stoke consumer prices. The break-even rate, the gap between yields on the bonds and nominal debt, is out of line with long- run measures of inflation, Morgan Stanley said.

Bonds have rallied worldwide this year as central banks stepped up or maintained stimulus and tumbling oil prices drove down inflation expectations. The Fed last week pared its forecasts for interest-rate increases as US policy makers prepare to tighten borrowing costs that have been held at a record low since 2008.

The US central bank recognizes "the asymmetric risks to hiking too soon versus hiking later when rates are at the lower bound," analysts at Morgan Stanley including London-based Chief Cross-Asset Strategist Andrew Sheets wrote in a report dated March 22. "The global growth backdrop continues to improve, supporting higher breakevens."

Ten-year TIPS yields were little changed on Monday at 0.1537 per cent as of 6:59 am New York time from Friday, when they declined for a fifth day. Nominal Treasury 10-year note yields were little changed at 1.92 per cent.

Ten-year break-even rates show investors expect US consumer prices to rise by 1.76 per cent a year for the coming decade, up from a 2015 low of 1.49 per cent seen on Jan. 14. The gauge climbed as much as nine basis points, or 0.09 percentage point, on March 19 as rising prices for TIPS pulled their yields down and further away from yields on benchmark 10-year notes.

US 10-year inflation expectations are on a par with Canada's as the second highest among Group-of-Seven peers.

"Inflation is low at the moment primarily because of the impact of oil price," said Philip Marey, a senior market economist at Rabobank Groep in Utrecht, the Netherlands.

"That means inflation should rebound by the end of the year. There is some opportunity," in TIPS, he said. "We still have our doubts about a June rate hike, the deflation story is still holding them back so they want to be sure that it's really temporary." TIPS pay interest at lower rates than regular Treasuries on a principal amount that's linked to the Labor Department's consumer price index.

Cleveland Fed President Loretta Mester said that it's appropriate for the Fed to raise rates this year as headwinds to the US economy are abating and that the lower oil price is positive. "I see some strength in the economy," she said in a Bloomberg Television interview in Paris on Monday.

Kim Youngsung, who helps oversee the equivalent of US$13.6 billion as head of overseas investment at South Korea's Government Employees Pension Service in Seoul, isn't convinced inflation will accelerate.

"I cannot see a sharp increase in terms of inflation in the near future," with oil and other commodity prices so low, he said. Mr Kim prefers 10-year nominal securities to equivalent maturity TIPS and short-term Treasury notes, which are more sensitive to changes in monetary policy.

The Bloomberg Commodity Index has fallen 5 per cent in 2015, extending a 17 per cent plunge last year that was the biggest since the financial crisis.

Fed Chair Janet Yellen reiterated her view March 18 that the impact from lower oil prices on inflation will be transitory.

US core inflation, which strips out volatile food and energy prices, probably advanced 1.7 per cent in February from a year earlier, according to the median estimate in a Bloomberg News survey of economists before the Bureau of Labour Statistics releases the data on Tuesday.

The Fed last week dropped a pledge to be "patient" in raising rates, saying instead it would wait until policy makers were "reasonably confident" that inflation is moving back to its 2 per cent target.

The change in wording put a rate increase into play at any meeting of the policy-setting Federal Open Market Committee starting in June. The FOMC also meets in July, September, October and December.

Traders predict 56 basis points of increases to the federal funds target rate over the next 12 months, down from 62 basis points on March 6, according to a Credit Suisse Group AG swaps index as of March 20.

Hedge funds and other large speculators trimmed bets on Treasury declines by the most in more than a month in the week ended March 17, according to data from the US Commodity Futures Trading Commission. They reduced net short positions by 30,727 contracts to 107,530 contracts in the period, compared with a 73,964 contract decline in the week to Feb 10 that took bearish bets to a more than three-month low of 44,816 contracts.

BLOOMBERG