Rising inflation may cause US bond yields to spike
Wednesday, 26 December 2007
aNEW YORK, Dec 25 (Reuters): Investors intent on sheltering assets from credit market upheaval and the risks of recession are so enamoured with safe-haven Treasury bonds they seem to have dismissed their usual concerns about inflation.
The latest headline US Consumer Price Index rose above the benchmark 10-year US Treasury note's yield for only the second time since December 1980, notes Bryan Taylor, chief economist with Global Financial Data in Los Angeles.
Low-yielding bonds are especially sensitive to rising inflation because it can quickly erase returns.
The only other occasion that inflation outstripped US Treasury note yields in the last 27 years was a brief moment in September 2005.
Given the current state of inflation, bond strategists are now starting to warn there's a growing threat that bond yields will spike-should food and energy prices stay high. That's a sobering prospect for investors in bonds because their prices fall when yields rise.
"When you are looking at 4 per cent-plus inflation, who would think 10- year notes at 4 per cent yield are a good place to hide out in a flight-to- quality trade?" asked Ted Ake, executive director and head of bond trading with Mizuho Securities USA in New York.
"I am an old school guy," Ake added. "Ten-year notes are supposed to trade off inflation. The Fed is telling you it's rising and the European Central Bank is telling you ... and China is worried about it."
On Monday, the nominal benchmark 10-year Treasury note was yielding 4.21 per cent, with the nominal 30-year bond yielding 4.61 per cent.
For now, most bond investors are betting that as the US economy edges toward recession, demand will ebb, putting a lid on consumer prices. Since inflation is a lagging indicator, that would be the textbook reaction of prices to the onset of a painful economic downturn.
Yet that logic may be flawed this time, some strategists argue.
Food prices, lifted to multi-year highs by volatile weather patterns, accelerating demand in faster growing economies, and the use of cereal grains in ethanol production, may keep rising.
Chicago Board of Trade corn futures CH8 soared to an 11-year high Friday, reflecting in part the demand for US corn to produce fuel. Wheat prices have more than doubled to record highs this
year in the United States and Europe.
And with US oil futures prices closing in on $100 per barrel, sky-high energy costs show no immediate sign of easing, either.
"Nominal Treasury yields in particular look especially low, should overall inflation be gaining some momentum," said William Sullivan, chief economist at JVB Financial Group, in a recent research note.
Nominal securities do not adjust for inflation, so their real rate of return is essentially the yield minus inflation.
With the overall US Consumer Price Index now running at a growth rate of 4.3 per cent year-over-year through November, and a 10-year US Treasury note yielding roughly 4.2 per cent, an investor will make a real return of minus 0.1 per cent on that note.
The jump of headline US CPI is probably not a one-off phenomenon, Sullivan added. US consumer price inflation expectations are growing, as a weekly drive to the supermarket brings tangible evidence of rising prices.
The Federal Reserve recently broadened its emphasis on inflation beyond the core measures that strip out food and energy, signalling to some analysts that policy-makers are worried headline inflation may become a real problem.
"Treasury yields are negative out to 10 years. Either CPI collapses, or yields climb sharply-or stagflation takes charge," wrote Donald Coxe, global portfolio strategist with BMO Capital Markets in Chicago in a December research report.
Until recently, only a small group of contrarians dared to warn about the danger of "stagflation," referring to the feeble economic growth accompanied by surging inflation that marked the oil shocks of the 1970s and 1980s, for fear of sounding alarmist.
The latest headline US Consumer Price Index rose above the benchmark 10-year US Treasury note's yield for only the second time since December 1980, notes Bryan Taylor, chief economist with Global Financial Data in Los Angeles.
Low-yielding bonds are especially sensitive to rising inflation because it can quickly erase returns.
The only other occasion that inflation outstripped US Treasury note yields in the last 27 years was a brief moment in September 2005.
Given the current state of inflation, bond strategists are now starting to warn there's a growing threat that bond yields will spike-should food and energy prices stay high. That's a sobering prospect for investors in bonds because their prices fall when yields rise.
"When you are looking at 4 per cent-plus inflation, who would think 10- year notes at 4 per cent yield are a good place to hide out in a flight-to- quality trade?" asked Ted Ake, executive director and head of bond trading with Mizuho Securities USA in New York.
"I am an old school guy," Ake added. "Ten-year notes are supposed to trade off inflation. The Fed is telling you it's rising and the European Central Bank is telling you ... and China is worried about it."
On Monday, the nominal benchmark 10-year Treasury note was yielding 4.21 per cent, with the nominal 30-year bond yielding 4.61 per cent.
For now, most bond investors are betting that as the US economy edges toward recession, demand will ebb, putting a lid on consumer prices. Since inflation is a lagging indicator, that would be the textbook reaction of prices to the onset of a painful economic downturn.
Yet that logic may be flawed this time, some strategists argue.
Food prices, lifted to multi-year highs by volatile weather patterns, accelerating demand in faster growing economies, and the use of cereal grains in ethanol production, may keep rising.
Chicago Board of Trade corn futures CH8 soared to an 11-year high Friday, reflecting in part the demand for US corn to produce fuel. Wheat prices have more than doubled to record highs this
year in the United States and Europe.
And with US oil futures prices closing in on $100 per barrel, sky-high energy costs show no immediate sign of easing, either.
"Nominal Treasury yields in particular look especially low, should overall inflation be gaining some momentum," said William Sullivan, chief economist at JVB Financial Group, in a recent research note.
Nominal securities do not adjust for inflation, so their real rate of return is essentially the yield minus inflation.
With the overall US Consumer Price Index now running at a growth rate of 4.3 per cent year-over-year through November, and a 10-year US Treasury note yielding roughly 4.2 per cent, an investor will make a real return of minus 0.1 per cent on that note.
The jump of headline US CPI is probably not a one-off phenomenon, Sullivan added. US consumer price inflation expectations are growing, as a weekly drive to the supermarket brings tangible evidence of rising prices.
The Federal Reserve recently broadened its emphasis on inflation beyond the core measures that strip out food and energy, signalling to some analysts that policy-makers are worried headline inflation may become a real problem.
"Treasury yields are negative out to 10 years. Either CPI collapses, or yields climb sharply-or stagflation takes charge," wrote Donald Coxe, global portfolio strategist with BMO Capital Markets in Chicago in a December research report.
Until recently, only a small group of contrarians dared to warn about the danger of "stagflation," referring to the feeble economic growth accompanied by surging inflation that marked the oil shocks of the 1970s and 1980s, for fear of sounding alarmist.