Inflation Hopes Spur Bond Rally -- Third-Quarter Report

Bond investors are starting to believe in inflation again.

The yield on the benchmark 10-year U.S. Treasury note settled at 2.328% Friday and posted its first quarterly gain of the year, buoyed by an uptick in consumer prices that lent support to some policy makers' insistence that inflation will soon make a long-anticipated return to the central bank's 2% target.

Yields soared into the end of 2016 as investors bet that Trump administration policies would spark a surge of growth and inflation. The so-called reflation trade petered out, however, after inflation remained tepid and the administration's legislative agenda stalled, with the 10-year yield posting declines in each of this year's prior quarters.

Now, investors are beginning to revive some postelection wagers. A rebound in consumer prices and the prospect of tax cuts spurred bond selling in recent weeks, with the 10-year yield falling just twice in the past 15 sessions.

"It's a hopeful sign of better things to come for the economy," said Thomas Roth, managing director in the rates trading group at MUFG Securities Americas Inc. "The market has a little more hope, as it did at the beginning of the Trump administration."

The 10-year government yield has spent the past six months locked in a range near 2.25% as the economy has maintained a slow and steady pace and as consumer prices showed few signs of gathering momentum. In September, it hit its lowest close since the election, 2.061%, as investors sought the relative safety of government debt as tension escalated between the U.S. and North Korea and investors worried about damages from recent hurricanes.

The yield rebounded later in the month, however, after the Fed's decision to push ahead with an aggressive schedule for rate increases, penciling in one more this year and three for 2018. And while some analysts still harbor doubts about the prospects for the passage of tax overhaul, or other elements of the Trump administration's agenda, several said they're starting to anticipate more stimulative fiscal policy.

"There is a lot that policy makers and the markets are watching, and nobody knows how it will work out," said Gemma Wright-Casparius, who manages inflation-indexed Treasurys at Vanguard Group.

The Fed's persistent advocacy for a brisk pace of rate increases has helped drive up yields on two-year Treasurys, which are more reactive to expectations for Fed policy, to their highest level since November 2008, before the nadir of the financial crisis. And as the Fed has raised rates, it also has succeeded in boosting inflation expectations, even as the failure of higher prices to materialize remains, in Fed Chairwoman Janet Yellen's words, a "mystery."

Fed-funds futures, which investors use to bet on central-bank policy, late Friday showed the chances that the Fed will boost rates for a third time this year at 78%, up from 34% a month ago, according to the CME Group.

Those expectations were key to the climb in yields, as prices for oil stabilized and the dollar continued its slide, boosting prices for commodities and making imports more expensive. Inflation is one of the biggest threats to the value of long-term government bonds because it erodes the purchasing power of their fixed payments.

Yields in the government-bond market indicate that investors are now forecasting inflation will average 1.8% during the next five years, approaching the 2% level reached in the wake of the election.

Some analysts suggest that the Republican tax proposal could present investors with an opportunity to revisit the reflation trade. But the difficulty policy makers have had in producing gains in wages and prices, even as the unemployment rate has fallen to 4.4% -- below the level where the Fed expects it to produce inflation -- makes some investors skeptical.

"Even if you get decent growth, the assumption that it will lead to inflation is something that you have to question now," said Krishna Memani, chief investment officer at OppenheimerFunds Inc.

The plan to lower both personal and corporate income taxes would give a modest boost to the economy. Goldman Sachs Group has estimated that one version of the Republican plan would add 0.6% to the nation's gross domestic product.

The proposal will face serious opposition, but if it gathers momentum, it could continue to push yields higher. The initial forecasts about the tax overhaul say it could lift growth, but the battle to get it passed, and the likely need for legislative compromises, may make it less attractive as time passes.

Investors should look at rising yields "as a trading process rather than as a long-term economic analysis" by the bond market, said Jim Vogel, head interest-rate strategist at FTN Financial.

(END) Dow Jones Newswires

October 01, 2017 07:14 ET (11:14 GMT)