By Richard Leong
NEW YORK (Reuters) - For Federal Reserve officials already worried about a persistent lack of U.S. wage and price growth, one corner of the bond market may be suggesting even more reason for alarm. The Treasury Inflation Protected Securities (TIPS) market is suggesting price stagnation may be just around the corner.
Slowing global growth, particularly because of weakness in Europe, as well as a surging dollar and plunging oil prices, have spurred selling in TIPS since late summer, disrupting a comeback they had enjoyed in the first eight months of the year.
TIPS, which provide protection for investors against rising inflation, are closely watched because they feature a measure of inflation expectations called breakeven yields. Keeping inflation expectations steady is one of the Fed s key goals.
Disinflation, or weak price growth, while not as harmful as deflation or a downward price spiral, hampers the economy as workers struggle to get bigger salaries and prices of assets, such as homes, appreciate only slowly. Fed officials, including Chair Janet Yellen, have repeatedly bemoaned the absence of wage growth for U.S. workers even as unemployment has fallen to the lowest since the financial crisis.
TIPS breakevens have been collapsing since early August. In the last three weeks, following the Fed s most recent meeting and an unexpected monthly drop in the benchmark U.S. Consumer Price Index on the same day in mid-September, the downward momentum in breakevens has been at its most intense since the financial crisis.
The CPI definitely set the tone. The stronger dollar and weaker energy prices are definitely having a major impact, said Martin Hegarty, co-head of inflation-linked bonds at BlackRock, the world s largest asset manager with .3 trillion under management.
Last week, for instance, 10-year breakevens, a gauge of where inflation will be in a decade, fell to their lowest since late 2011. They dropped below the key 2 percent level targeted by the Fed at the end of last month. On Friday, they ended at 1.97 percent.
The market is readjusting its global growth expectations, said Gemma Wright-Casparius, who oversees Vanguard s .1 billion TIPS fund, the biggest U.S. fund of its kind.
Only last week, the International Monetary Fund downgraded its forecast on global growth this year to 3.3 percent from the 3.4 percent it previously expected, and gave worryingly high probabilities for recession and deflation in Europe.
DOLLAR, OVERSEAS WORRIES
Since last month s Fed s meeting, interest rate futures markets have pushed estimates for when the Fed will finally start to raise rates further into 2015. At that meeting, Fed policy makers declined to make an anticipated change to their forward guidance for interest rates because they were concerned about anemic wage growth and other slackness in the economy.
It is now seen as a toss-up whether the Fed moves before next September, whereas in late summer odds were tilted toward an increase as early as June.
There is no sign of wage inflation. Until that changes, there will be no rush to raise the funds rate, said Bill Irving, a Merrimack, New Hampshire, portfolio manager at Fidelity Investments, which manages trillion.
Meanwhile, New York Fed President William Dudley and a few other policy makers have raised red flags about the stronger dollar, which strengthened in the third quarter by 7.7 percent, the most in six years. That makes imported goods cheaper for U.S. consumers, but can stunt growth in U.S. exports at a time when key trading partners in Europe and Asia are struggling to keep their economies on track. Weaker exports would be an unwelcome headwind for the U.S. economy.
Still, worry about the dollar s strength may be overblown, some analysts say, because the United States is less dependent on exports than China, Japan and Germany for growth.
The inflation market is having a complete over-reaction to a stronger dollar, BlackRock s Hegarty said.
Recently, though, another factor has emerged to exert more pressure on the inflation outlook: plunging oil prices. Global oil prices late last week hit their lowest levels since 2010 and are now down 25 percent since June.
All this has translated into a big hiccup for what had been a major comeback year for TIPS after they suffered their worst-ever performance in 2013, when the Barclays TIPS index declined by 8.6 percent.
Since the beginning of September, the index has fallen 1.4 percent. Before then, TIPS had generated a 6.3 percent return from January to August, outperforming the broader bond market.
Meanwhile, investors have pulled money from TIPS-focused funds for six straight weeks, withdrawing more than .1 billion in that span, according to Lipper, a unit of Thomson Reuters. That has cut assets in TIPS funds to .1 billion, the lowest since April.
Some of the selling in the last two weeks was exaggerated by renowned bond investor Bill Gross s surprise departure from Pimco for Janus Capital Group. Pimco s flagship Pimco Total Return Fund, the world s largest bond portfolio with about 0 billion in assets, had hefty TIPS exposure, and traders reasoned the firm might cut that to raise cash for the fund redemptions it faced when Gross left.
Investors pulled .9 billion from the Pimco Total Return Fund in September, according to Morningstar.
That was another massive hit to the TIPS market, said Aaron Kohli, BNP Paribas interest rate strategist in New York.
(Reporting by Richard Leong; Editing by Dan Burns and Martin Howell)
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