Evaporating inflation may have taken pricy debt too far

By Mike Dolan

LONDON (Reuters) - The prospect of years of so-called 'low-flation' has become so ingrained in western financial markets this year that even a hint of creeping prices could deliver quite a shock.

One of the investment surprises of 2014 so far has been the rebound in government bonds as equities and emerging markets wobbled and Ukraine-related geopolitics conjured up a safety bid in core debt holdings such as U.S. Treasuries and German bunds.

The move wrongfooted many. Historically expensive government bonds, with record low yields, had been labelled 'toxic' by some strategists as they eyed recovering economies, waning systemic threats and a renewed appetite for equity.

But the big driving force this year has been subdued or even evaporating headline inflation that has sustained or even enhanced inflation-adjusted returns on fixed income securities, even as the recovery of underlying economies continued apace.

As euro zone inflation sank below 1 percent, European government bonds across the core and periphery of the bloc pushed higher and were then supercharged by signals from the European Central Bank it might cut interest rates or even embark on some form of asset purchase scheme as soon as next month.

Take Ireland as an example.

Economists at Brown Brothers Harriman point out that annual inflation fell to just 0.4 percent last month from a peak of 2.6 percent in August 2012. That's a decline some 80 basis points bigger than the 140 bp drop in Ireland's 10-year bond yield over the same period - leaving real yields higher than two years ago.

"As fast as bond yields have been falling, so too has inflation, meaning that real yields have maintained their value," said Tanguy Le Saout, Head of European Fixed Income, Pioneer Investments.

Despite more brisk underlying recoveries, U.S. and British inflation rates too have fallen below or remained well under the stated or notional 2 percent central bank targets.

For many, this inflation story is no fluke and frames the world economic and investment outlook for years to come.

The latest 3-5 year outlook sketched by the world's biggest bond manager Pimco tweaked the firm's long-standing 'New Normal' view of slow growth and low returns into a 'New Neutral' period of "exceedingly low" official interest rates over time.

The gist, and one that echoes former U.S. Treasury chief Larry Summers' idea of 'secular stagnation', is that official interest rates will not return to pre-crisis norms in a way that financial markets still assume they will over the coming years.

Zero percent neutral real policy rates for many developed and even some emerging countries will be the investment outcome.

"If the future resembles those neutral policy rates, then the investment implications are striking," Pimco's Bill Gross told clients. "Low returns yet less downside risk than investors currently expect; an end to bull markets as we've known them, but no perceptible growling from bears."

CREEPING PRICES?

The view catches the zeitgeist of 2014 so far, even if you might expect a bond-friendly view from a bond fund manager that had investors pull $82 billion from its funds since last June.

But after a torrid 2013, all bond categories have rallied.

Year-to-date returns on everything from 10-year U.S. Treasuries to German bunds, global high-grade and junk corporate debt or even hard currency emerging market bonds are between 4 and 7 percent. Italian government bonds are up 10 percent.

And all outperformed the 3.4 percent gain on the S&P500 of leading Wall St stocks.

So is inflation really as dead as that appears to suggest?

There's certainly been no sign of the galloping price rises that some feared would be stoked by successive bouts of money printing. Still substantial slack in labour markets and spare capacity in economies at large suggests little pressure by way of wage inflation.

But with bonds priced for such extraordinarily low inflation for years to come, the risk is then just a return to normal.

And with U.S. consumer price inflation expected to have topped 2 percent last month for the first time in 18 months, there's more than a murmur to worry buoyant bonds.

State Street's proprietary PriceStats survey of U.S. online prices also shows inflation at a brisk monthly clip of 0.35 percent in May. "The weakness of Q1 GDP will cast doubt over the strength of the recovery, but online retailers do not seem to have such doubts," it said. "Their pricing remains consistent with solid demand conditions."

A debate about the speed of wage rises is also heating up.

Barclays economist Dean Maki said growth in U.S. average hourly earnings for production and non-supervisory workers rose 2.3 percent in the year to April, up from a trough of 1.3 percent in October and at a level in prior cycles that equated to a jobless rate of 5.4 percent - not the current 6.3 percent.

And in Europe too, the inflation swoon could well have run its course. Pioneer's Le Saout said inflation forecasts for the remainder of 2014 show slow rises towards 1 percent and above and core inflation is already at that level.

"Inflation is low but has probably rock-bottomed," said Marion Le Morhedec, senior portfolio manager at AXA Investment Managers.

(Editing by Mark Trevelyan)