By Burton Frierson - Analysis
NEW YORK (Reuters) - Soaring U.S. bond yields may suggest inflation fears are burning out of control, but a closer look exposes more smoke than fire.
Investors have been dumping Treasury bonds after coming to the conclusion central banks around the world would keep interest rates higher for longer than many had predicted.
Inflation is certainly playing a role, but mainly because the market believes the Federal Reserve will enforce a tight monetary policy to keep price pressures contained, rather than the conviction that it is already out of control.
This is a subtle but importance difference. Investors are concerned about the rising cost of capital, not losing ground to inflation.
Since many had earlier positioned for a cut in U.S. interest rates this year by pushing yields well below the benchmark 5.25 percent federal funds rate, it was a losing prospect to keep them there once those expectations changed.
The rise in yields in turn has led to a wave of readjustments in other fixed-income markets, such as mortgage securities, and this has exacerbated the selling in Treasuries.
"We really have not seen a lot of inflationary pressures," said Bernd Wuebben, senior bond market strategist with BNP Paribas in New York.
"It's a fear of higher rates, global higher rates, and that is sort of pulling U.S. rates with it -- a general global shift out of the bond market."
HANG YOUR HAT ON TECHNICALS
The government's latest inflation report showed overall U.S. consumer prices rose less than expected in April. The underlying, or core Consumer Price Index, posted a 12-month gain of 2.3 percent, the smallest in a year.
This is still above the Fed's comfort zone of 1-2 percent and explains why policy-makers have maintained inflation vigilance as their main message.
But Fed rhetoric alone does not explain the ferocity of a bond market rout that pushed 10-year Treasury yields (US10YT=RR: Quote, Profile, Research up half a percentage point since early May. The Fed warned consistently in recent months inflation was a risk, with no such ripples.
"A bunch of people just gave up on rate cuts and threw in the towel last week," said David Coard, head of fixed-income sales and trading at The Williams Capital Group.
"But there are those who are trying to justify what's happening by saying inflation is a problem. I think the trend in inflation has been favorable, unless I'm missing something."
One missing link is the mortgage market. Hit hard by the rise in yields, investors in that sector were forced to trim their portfolios' duration, or rate sensitivity, by selling Treasuries.
"I am not a believer of the inflation story," said Bret Barker, portfolio manager of Treasuries at Metropolitan West Asset Management in Los Angeles.
"I usually hate to hang my hat on technicals but more than anything this feels like a massive long duration liquidation."
DOING THE FED'S JOB
That is not to say that price pressures should be ignored completely. Inflation-linked bonds have given mixed signals. They showed some heightened inflation concern in recent days, but only after a steep decline in previous months.
And while some measures of inflation have come down to the top of the Fed's comfort band, the newest data on the popular Consumer Price Index is expected to show inflation excluding food and energy remained around 2.3 percent in May, still above the central bank's preferred range.
The consumer price report is even more crucial after last week's data showing worker productivity growth slowed more than earlier thought in the first quarter, driving up labor costs.
Yet even this discomfort might eventually be soothed by higher Treasury yields themselves, since they are used to price credit throughout the economy. The could therefore crimp consumer spending and could damp economic growth.
Hit by a sharp slowdown in the housing sector, gross domestic product rose just 0.6 percent in the first quarter, its slowest in four years.
Many analysts believe it will bounce back, but higher borrowing costs could restrain that rebound. This, in turn, would cool inflation, helping the Fed do its job.
"The problem that got first-quarter GDP to where it was...is not going away," said William O'Donnell, head of U.S. interest rate strategy and research with UBS in Stamford, Connecticut. "If anything it is made worse by the conditions in the bond market of late."
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