Pimco forecast for quicker inflation clashes with bond market

[NEW YORK] Pacific Investment Management Co says US inflation will pick up - at a time when the Treasury market is signaling the opposite.

Investors should brace for inflation gains and the prospect that the Federal Reserve may raise interest rates more quickly than forecast, according to Pimco, which runs the world's biggest actively managed bond fund.

"Markets are probably pricing insufficient tightening by the Fed, based on our baseline forecast of above-potential growth and inflation getting back to the Fed's 2 per cent target over the next four quarters," Richard Clarida, Pimco's global strategic adviser, and Andrew Balls, the chief investment officer for global fixed income, said in a report Tuesday.

It's another story in the bond market. The difference between yields on one-year debt and similar-maturity Treasury Inflation Protected Securities, a gauge of expectations for consumer prices, fell to minus 1.83 per centage points Tuesday, the lowest closing level since February 2009, indicating investors are bracing for prices to fall in the next 12 months.

The debate over the outlook for prices is intensifying after the Fed surprised some investors by keeping its main interest rate unchanged at a meeting last week. The central bank cited downward pressure on inflation as it decided to extend its six-year run of record low borrowing costs. Fed Chair Janet Yellen is scheduled to speak Thursday on inflation and monetary policy.

Yields on the part of the US Treasury curve that are most sensitive to a Fed increase remain stubbornly low. Treasury two- year yields fell by the most in six years after the central bank held interest rates unchanged last week.

"Those prices have overshot," Clarida said in an interview. "There will be a liftoff. At the very front end of the US curve, you are not compensated fully for that liftoff probability."

Two-year notes advanced on Tuesday after the government sold US$26 billion of the securities at a yield of 0.699 per cent, the highest at an auction since December. The five-year note due to be auctioned Wednesday yielded 1.48 per cent in pre-auction trading.

Treasuries erased earlier gains Wednesday after a rebound in stocks reduced demand for haven assets and before the US government sells $35 billion of five-year debt. The benchmark US 10-year yield rose three basis points, or 0.03 percentage point, to 2.16 per cent as of 9:39 a.m. New York time, having dropped as much as three basis points earlier. The 2 per cent note due August 2025 fell 7/32, or $2.19 per $1,000 face amount, to 98 18/32.

"It seems stocks and sentiments are the key drivers at the moment," said John Stopford, head of fixed income at Investec Asset Management in London. "Treasury yields have come a long way, and a market view that the Fed will at one point have to raise interest rates, albeit at a gradual pace, will limit the scope of a decline in yields."

Inflation will accelerate as the effects of falling oil prices and the stronger dollar fade, according to Pimco. Treasury Inflation-Protected Securities are attractive, Clarida and Balls wrote. A rising greenback makes it cheaper for Americans to buy goods from abroad.

The US consumer price index has been close to zero all year. Pimco expects economic growth in the range of 2.25 per cent to 2.75 per cent over the next four quarters and CPI inflation of 1.75 per cent to 2.25 per cent.

TIPS have handed investors a loss of 0.9 per cent in 2015, versus a 1.4 per cent return for conventional Treasuries, according to Bank of America Corp. data.

Traders are pricing in a 43 per cent probability of the US central bank raising the benchmark rate by its December meeting, compared with 64 per cent before the Fed's latest policy decision on Sept 17. That's based on the assumption that the effective fed funds rate will average 0.375 per cent after the first increase.

BLOOMBERG