Yellen's gradual policy path backed by slumping inflation view

[TOKYO] 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, held near 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-normalization of rates."

The benchmark US 10-year note yield was little changed at 2.32 per cent as of 6.48 am in London, according to Bloomberg Bond Trader data. The price of the 2.125 per cent security due in May 2025 was 98 1/4.

Securities yielded 0.48 per cent. The US plans to auction US$15 billion of the bonds on Thursday.

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 3.07 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."

BLOOMBERG