Bond market backs mild inflation in swap forwards

In the US bond market, the new normal is looking a lot like the old normal. Interest-rate derivatives show traders anticipate economic growth that fails to spark runaway inflation even as global food and energy prices soar and the Federal Reserve pumps $600 billion into the financial system by purchasing bonds. Based on where they see 10-year swap rates in a decade, the cost to lock in fixed rates in exchange for floating interest payments is the same now as it was before the worst financial crisis since the Great Depression.

For DoubleLine Capital LP in Los Angeles, which oversees $8 billion, the worst is over for the sell-off that drove 10-year Treasury yields as high as 3.77 per cent this month from 2.33 per cent in October. The notes yielded 3.51 per cent as of 10.41 am today in London.

 

“Ten-year yields have gotten to an appropriate level given the pace of the economic expansion and inflation expectations,” said Gregory Whiteley, a DoubleLine manager who says he would be a buyer if yields climbed to 4 per cent for the first time since April. “Housing and stresses in state and local government finances will be a drag on growth. If yields moved over 4 per cent it would attract demand from investors, including foreign central banks.”

The class of investors that includes foreign central banks bought a record 71 per cent, or $17 billion, of the $24 billion in 10-year notes sold by the government in its latest auction on February 9, according to the Treasury Department.

‘New world’
“Unless you think we are in a completely new world, which some people do, the inflation-adjusted forwards show that we are right back into the middle of the range that existed since the mid 1990s,” Dominic Konstam, New-York based head of interest- rate research at Deutsche Bank AG, said in a telephone interview.

Forward contracts on interest-rate swaps that allow investors to lock in fixed-rate payments for 10 years a decade from now have risen to 5.26 per cent, or where they were before the collapse of Lehman Brothers Holdings Inc deepened the financial crisis in 2008. When adjusted for so-called core inflation, they’re back to 2004 levels, Deutsche Bank data show.

Even if consumer prices excluding food and energy costs were to triple this year from January’s 0.2 per cent increase, the so-called 10-year, 10-year forward rate would only fall to about 3.5 per cent, within the top end of its range back through 2005, according to Deutsche Bank.

The 10-year note’s yield will end the year at 3.75 per cent, after first falling to 3.5 per cent in the second quarter, according to the bank. The median estimate of 64 economists surveyed by Bloomberg is 3.93 per cent at year-end.

Pimco’s view
Bill Gross, who runs the world’s biggest bond fund at Pacific Investment Management Co, reduced his holdings of government related debt to the lowest level since January 2009 while saying low yields cheat investors. Gross cut the proportion of US government and related securities in Pimco’s $239 billion Total Return Fund to 12 per cent of assets in January from 22 per cent in December, according to the Newport Beach, California-based company’s website.

Policy makers are robbing savers by driving down real interest rates as they keep borrowing costs at record lows in a “devil’s bargain,” Gross wrote in his monthly investment commentary on February 2. He advised investors to reduce holdings of Treasuries and UK gilts and buy higher-returning securities such as debt from emerging-market nations.

Mohamed El-Erian, who serves as co-chief investment officer with Gross at Pimco, coined the term “new normal” to describe what he forecasts is an era of prolonged below-average global economic growth and investment returns.

Commodities soar
Government bond yields have risen as prices of commodities from oil to wheat surged. Higher demand in emerging-market countries, drought in Russia and China, and flooding in Australia have sent corn futures up 95 per cent in the past year, while wheat jumped 71 per cent and soybeans advanced 44 per cent. Snows in North America drove heating oil contracts up 32 per cent.

The World Bank’s food-price index climbed 15 per cent between October and January, and President Robert Zoellick said on February 16 that rising food prices have been an “aggravating factor” in the unrest in Africa and the Middle East. The gauge is 3 per cent below its 2008 peak, when surging costs sparked riots in more than a dozen countries.

Fed policy makers don’t expect increases in commodity prices to filter into broader inflation permanently, according to the minutes from the January 25-26 Federal Open Market Committee meeting released last week.

While prices of some “highly visible” items such as gasoline have “significantly” increased, “overall inflation remains quite low” and wage growth has slowed, Fed Chairman Ben S Bernanke said in a February 3 speech at the National Press Club in Washington.