Bond Rally Seen on Collision Course With Inflation as Fed Punts

A rally in the $13.3 trillion market for U.S. government debt faces headwinds amid mounting evidence that consumer price gains are starting to accelerate.

U.S. 30-year securities, the maturity most sensitive to inflation, rose for a second week even as a bond-market measure of consumer-price expectations closes in on its highest level this year. Goldman Sachs Group Inc. says the Fed’s preferred measure of inflation will end the year at about 1.8 percent, above even the central bank’s current forecast of 1.6 percent.

Inflation is a risk that "is new and coming into focus" said Richard Turnill, global chief investment strategist at BlackRock Inc., in an interview Thursday with Bloomberg Television. "Investors should be watching very closely for any signs that inflation expectations are picking up, that core inflation itself is picking up.”

While inflation is bad for bonds because it erodes the value of fixed Payments , Treasuries have gained in the face of rising oil prices and data showing an improving U.S. economy. That has sparked concern that the market isn’t adequately pricing the risks and investors may be caught off guard when yields move higher. The Fed last week kept its benchmark interest-rate target unchanged while projecting two increases later this year.

Benchmark U.S. 30-year yields fell one basis point this week, or 0.01 percentage point, to 2.67 percent in New York, according to Bloomberg Bond Trader data. The price of the 2.5 percent note due in February 2046 was 96 13/32.

Fed Bank of St. Louis President James Bullard, who votes on policy this year, said the U.S. central bank should consider rate increases sooner than later, in part because of the prospect of inflation overshooting the Fed’s target.

“Wages, according to anecdotal reports, will be picking up,” Bullard said after a speech Thursday in New York. "You have to react to the data and I have been a champion of that."

Flatter Curve

The 30-year Yield has also been falling because of the so-called flattener trade, selling shorter-term securities and buying longer-term debt. The yield on the two-year note rose this week, narrowing the gap with the 30-year bond to as low as 1.75 percentage points, close to the least since 2008.

"People feel relaxed about the threat from global growth and inflation," said David Keeble, New York-based head of fixed-income strategy at Credit Agricole SA. "The 30-year is looking at global inflation trends. The short end of the curve is domestic."

Core personal consumption expenditures rose 1.8 percent on a year-over-year basis in February, according to a Bloomberg survey before the March 28 report. A separate report April 1 is forecast to show the U.S. added 207,000 jobs, while hourly earnings climbed 2.3 percent from a year earlier.

The gap between yields on 10-year Treasuries and equivalent inflation-indexed securities, a gauge of trader expectations for consumer prices over the life of the debt, climbed as high as 1.67 percentage points this week, the highest since August.

The Fed "is going to be forced to react more aggressively" if it falls behind the curve on inflation, BlackRock’s Turnill said.

The U.S. will auction $26 billion of two-year securities on March 28. It will sell $34 billion in five-year notes March 29 and $28 billion in seven-year debt March 30.

To contact the reporter on this story: Susanne Walker Barton in New York at swalker33@bloomberg.net. To contact the editors responsible for this story: Boris Korby at bkorby1@bloomberg.net, Paul Cox

By: Susanne Walker Barton

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