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September 23, 2014 4:08 pm

Treasury market cuts US inflation outlook

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(FILES) File photo dated August 09, 2011 shows the US Federal Reserve building in Washington, DC. The Federal Open Market Committee's (FOMC) regular policy-setting meeting starts September 20, 2011 in Washington. The threat of inflation is expected to temper any decisions on new pro-growth measures when Federal Reserve policy-makers meet Tuesday on the US economy's poor health. With growth stagnating and unemployment stubbornly above nine percent, analysts say they expect the Federal Open Market Committee to take some action to stimulate the US economy. AFP PHOTO/KAREN BLEIER (Photo credit should read KAREN BLEIER/AFP/Getty Images)©AFP

The US bond market has slashed expectations of future inflation to their lowest level in nearly three years, highlighting the challenge facing the Federal Reserve as it moves towards ending easy money policy.

Expectations for inflation over the next five years, as measured by comparing yields on Treasury inflation protected securities and those of nominal Treasury bonds, have approached their double low of June 2013 and December 2011.

The Fed pays close attention to market expectations of inflation and has stressed a desire to see annualised consumer prices rise above their target of 2 per cent, undertaking several rounds of quantitative easing in order to accomplish that goal since 2008.

Now as the Fed’s current bond purchases are set to end next month, the Treasury market is signalling that inflation pressures are easing and may fall further below the central bank’s target. That could well delay expectations of tighter interest rate policy by the Fed next year.

Speaking on Monday, William Dudley, president of the Federal Reserve Bank of New York said: “We really need the economy to run a little hot, at least for some period of time” to get inflation back to the central bank’s objective.

Recognising the recent decline in consumer price pressures, the Federal Reserve’s policy statement for September last week noted inflation was “running below” its target, rather than moving “somewhat closer” as was written back in July.

A drop in the so-called break-even rate for the next five years towards 1.62 per cent from 2.1 per cent earlier this summer, reflects the influence of a stronger dollar and lower commodity prices that have reduced inflationary pressure in recent months.

US bonds 1

That backdrop has prompted a rout in the inflation insurance market say traders as investors pull back from buying insurance against the risk of rising consumer prices.

“Inflation break-evens have been a one-way trade and will soon be the subject of Fed comments,” said Richard Gilhooly, strategist at TD Securities. He said a decline in five-year break-evens below 160 basis points “will further emphasise the [Fed’s] statement that inflation is running below its long-run objective”.

The shift lower for break-evens accelerated after last week’s inflation data for August revealed a surprising drop in US consumer prices, with the annualised core rate, which strips out food and energy prices, easing to 1.7 per cent for the twelve months ending in August, down from July’s 1.9 per cent.

US bonds 2

“There is virtually no real inflation, or signs of it accelerating,” said James Sarni, managing principal at Payden & Rygel.

Mr Gilhooly added: “We see little reason to buy [inflation protection] with commodities under pressure from the slowdown in China and US dollar strength.”

In early trading, Tuesday the five-year breakeven had rebounded to 1.67 per cent with traders saying the market was due for a bounce after several days of selling. “We would take advantage of the higher level of break-evens to reduce exposure to inflation, arguing that an oversold reading is not a reason to buy other than to capture a short-term bounce,” said Mr Gilhooly.

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