An extended bout of low prices and tepid wage growth are showing signs of ending and that has government-bond investors bracing for a new inflation regime.
Rising inflation is anathema to bonds because it can erode the security’s fixed value, which is a notable headwind for longer-dated government paper.
Contributing to the anticipation of higher inflation are climbing commodity prices, improving global growth and lingering fears that tightening labor markets will eventually translate into higher wage gains. That has stoked fears that a pick up in what has otherwise been stubbornly low inflation will blindside Treasury buyers.
Investors appear to be guarding against an unwelcome surprise, with an auction in Treasury inflation-protected securities, or TIPs, on Thursday afternoon proving strong, driving up expectations for future inflation to a 3-year high.
The 10-year break-even rate rose 3.5 basis points to 2.09%, the highest since September 2014, according to Tradeweb data. The rate, a gauge of bond-market participants’ expectations for inflation over the next decade, is the difference between the yield of a 10-year Treasury note
and a comparable inflation-linked bond. One basis point is equivalent to a hundredth of a percentage point.
TIPs can be viewed as one market-based measure of the outlook for inflation, signaling what investors are willing to pay to protect themselves from rising prices.
“To the extent that people have money to put to work in fixed income, they’re trying to invest it in something that will hold its value best in case inflation moves from an upward slant to a full roar,” said Jim Vogel, interest-rate strategist for FTN Financial.
Indeed, inflows into TIPs have gradually accelerated toward the end of 2017, as the chart below illustrates:
Moreover, recent data have supported the view that inflation may be making a comeback. The Federal Reserve’s Beige Book on Wednesday noted anecdotally that employers were beginning to raise wages to attract workers. Core consumer prices, which strip out for volatile food and commodity values, rose 0.3% in December, above the 0.2% forecast by economists polled by MarketWatch.
Demand for TIPs also comes as the 10-year Treasury note yield topped 2.6%, close to its highest levels in 2017 when expectations of President Donald Trump’s pro-growth agenda sparked a bond-market rout, driving yields, which move inversely to bond prices, decidedly higher amid concerns of an overheated economy and a heightened inflation outlook.
Thursday’s TIPs auction was impressive in at least one regard. Indirect buyers, a proxy for foreign investors, took down 79% of the offering, their second largest all-time share.
Primary dealers ended up with 10% of the total bonds sold, a record low. Primary dealers, mostly consisting of big banks, are obligated to put in a pro rata share of bids to retain the privilege of directly buying and selling Treasurys. A weak auction will leave such trading desks to scoop up the remaining unsold securities.