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Yellen's gradual policy path backed by slumping inflation view

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Janet Yellen's emphasis on a gradual path to higher US interest rates is getting support from a slump in investors' inflation expectations.

[WASHINGTON] Janet Yellen's emphasis on a gradual path to higher US interest rates is getting support from a slump in investors' inflation expectations.

The 10-year break-even rate, derived from the difference between nominal and index-linked bonds, fell to 1.83 percentage points Tuesday, the lowest close since June 1. The spread between two- and 30-year yields, which is also influenced by the inflation outlook, is the narrowest in more than a month. The Federal Reserve Chair told the Senate Banking Committee last week she prefers to "tighten in a prudent and gradual manner." Subdued consumer-price gains lessens pressure to tighten monetary policy.

"I certainly don't subscribe to there being any inflation fears, that's for sure," said Damien McColough, an interest- rate strategist at Westpac Banking Corp. in Sydney. "The message around long-end rates is that Yellen is talking about a gradual tightening cycle. And it's not even a tightening cycle - it's the beginning of a re-normalisation of rates." The benchmark US 10-year note yield was little changed at 2.33 per cent as of 1:25 pm in Tokyo, according to Bloomberg Bond Trader data. The price of the 2.125 per cent security due in May 2025 was 98 1/4.

Ten-year Treasury Inflation Protected Securities yielded 0.48 per cent. The US plans to auction US$15 billion of the bonds on Thursday.

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TIPS have lost 0.3 per cent this month, on track to underperform conventional debt for a third straight month, according to Bank of America Merrill Lynch indexes. The consumer-price index has been at 0.1 per cent or lower every month this year.

Futures show a 33 per cent chance the Federal Open Market Committee will raise borrowing costs in September, and 68 per cent odds by year-end, according to data compiled by Bloomberg.

Two-year notes - which are more sensitive to monetary- policy expectations - yielded 0.68 per cent, compared with 3.06 per cent for 30-year bonds. The spread earlier contracted to 237 basis points, the narrowest since June 17.

"The Fed probably doesn't want to wait until we hit exactly their targets - they need to act before, as long as they have enough confidence that we will eventually reach those targets," Hartmut Issel, Singapore-based chief investment officer for UBS AG Wealth Management, said in an interview with Bloomberg, adding he is "very overweight" US high-yield bonds. "You don't want to be behind the curve."

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