Debate in Treasury market

Bond traders about to see if they’re underrating inflation risks

NEW YORK: A debate is breaking out in the Treasury market before Wednesday’s release of US consumer-price data as tumbling crude oil leads investors to ratchet back inflation expectations.

In one camp, you have the likes of Societe Generale SA. The bank sees price pressures building into 2019, fuelling demand for inflation protection, in part as investors anticipate more US tariffs on Chinese goods.

Morgan Stanley agrees, saying the import levies and job-market strength should pressure consumer prices higher next year.

Traders are skeptical. The fiveyear breakeven rate – which represents investors’ view on the annual inflation rate through 2023 – has dropped to 1.9%, close to the lowest since January, from a 2018 high of 2.19%.

Given that the lowest jobless rate since 1969 has yet to cause a jump in inflation, the market’s take is likely spot-on, according to BMO Capital Markets.

“It’s a rational response to the fact that we’re notably through sustainable unemployment levels and you’re not seeing broad pick-ups of inflation,” said BMO rates strategist Jon Hill.

“We’re seeing this as an indication of building concerns about global growth several quarters out.”

The biggest question for bond investors is whether policymakers agree with their tempered outlook for consumer prices, or foresee accelerating inflation that could require additional rate hikes.

Traders will get a read on that when Federal Reserve chairman Jerome Powell speaks on the economy on Wednesday evening in Dallas, following the Labour Department inflation data due that morning.

Benchmark 10-year yields pulled back from close to a seven-year high as stocks and oil sank at the end of last week, closing at 3.18% on Friday.

The spread between 2- and 10-year Treasury yields flattened by the most since August as markets turned their focus back to the Fed’s tightening path in the wake of the US mid-term elections.

Traders are pricing in nearly two quarter-point rate hikes in 2019, after an expected tightening in December.

The consumer price index (CPI) figures are the next key for the inflation debate. Consumer prices likely rose by 2.5% in October from a year earlier, according to a Bloomberg survey of economists, after a 2.3% increase in September.

The CPI report is generally expected to be in sync with other data indicating steady progress on the Fed’s 2% inflation goal.

“The fundamental forces all point to higher inflation,” said Stephen Stanley, chief economist at Amherst Pierpont Securities LLC. “From here on, the risks are easily more to the upside than the downside. We’re going to get a significant overshoot on the inflation target.”

Morgan Stanley in a note last week said it found Treasury Inflation-Protected Securities (TIPS) and CPI swaps “highly disconnected” with the likely path of consumer prices in the year ahead.

It recommended going long frontend TIPS on a breakeven basis, or one-year CPI swaps.

BMO sees a different scenario playing out. Plunging crude prices could be a sign of things to come should the US-China trade spat dent Chinese growth, reinforcing the argument for the decline in breakeven rates.

“If you get a slowing Chinese economy, that would have less global demand for commodities, which would be yet another downside risk to inflation,” said BMO’s Hill.