By Karen Brettell
NEW YORK, June 25 (Reuters) - U.S. inflation-linked
government bonds have tumbled to levels that analysts say
approach those common in periods of financial crisis, a sharp
turnaround for what has been one of the best-performing bond
classes in recent years.
Bond markets around the world have been rocked by the shift
in thinking from the U.S. Federal Reserve, which Fed chairman
Ben Bernanke made clear last week when he said the U.S. central
bank may start paring bond purchases later in the year.
But the relative illiquidity of Treasuries
Inflation-Protected Securities and the large number of long
positions in that market made the rout in these securities even
worse as investors headed for the exits. TIPS have been strong
performers in recent years as investors sought protection on the
expectation that bond purchases would increase inflation.
That hasn't happened, however, and the bonds dramatically
worsened after Bernanke downplayed concerns about low inflation,
stating that he expects price pressures to rise back to the
Fed's targets. Bernanke focused instead on the improving economy
and falling unemployment rate.
"The market is unprotected, where it thought it had a little
bit of protection in the form of the Fed," said Aaron Kohli, an
interest rates strategist at BNP Paribas in New York. "It's
showing you that there is a good risk of financial stress, that
there are liquidity concerns ahead."
Many TIPS funds have been left smarting from the turmoil.
The two worst-performing fixed income funds year-to-date are
TIPS funds, according to Lipper, a Thomson Reuters company.
The DFA Dimensional Retirement Fixed Income Fund,
with $2.1 million in assets, is down 23.1 percent on the year
while the $350 million Pimco Real Return Asset Fund
has lost 16.4 percent, Lipper data show.
Inflation measures have tumbled and are well below the Fed's
long-term target of around 2 percent. Personal Consumption
Expenditures (PCE) fell to a record low 1.05 percent on the year
in April, the most recent data available. The Consumer Price
Index (CPI) is running at 1.4 percent.
For investors in TIPS and other inflation products,
Bernanke's comments came as a shock, as they expected purchases
would continue until inflation was rising at the upper end of
Fed targets. It is also leaving them flummoxed over what the
impetus for rising prices will be without Fed stimulus in an
improving but still lackluster economic recovery.
"The raw fuel for inflation is there, but it doesn't
necessarily mean that it gets a spark to ignite it," said
Stewart Taylor, co-portfolio manager of the Eaton Vance Short
Term Real Return Fund in Boston, which invests in
short-dated TIPS. That fund is down 1.7 percent this year.
Inflation expectations as measured by TIPS bonds have
plunged, with 10-year levels dropping below the key 2 percent
level that in the past has been associated with more Fed
stimulus, not less. It hit a low of 1.80 percent on Monday
before rising to about 1.96 percent on Tuesday. If the low
levels persist, it may complicate the Fed's ability to exit from
its bond-buying strategy.
The rate has only dropped below 2 percent two other times
since the failure of Lehman Brothers in 2008 sparked a
deflationary shock that initiated the Fed's unconventional
policy. In each case - in late 2010 and 2011 - the Fed responded
with new rounds of bond purchases, or quantitative easing, that
sent inflation expectations back above the 2 percent level.
"In the last 10 years we haven't been below this level of
inflation for a very long period of time, it should be
concerning the Fed right now. All of the latest round of QE has
been undone in a matter of weeks," Kohli said.
Analysts note that moves have been exacerbated by
illiquidity, as TIPS represent only around 10 percent of
outstanding U.S. government debt.
Pension funds, hedge funds and other institutional investors
that bought TIPS in expectation of higher inflation headed to
the exits at the same time, while banks that have been shrinking
their balance sheets have been less able to absorb the selling.
"It's a one-sided market and everyone is looking for bids,"
said Richard Gilhooly, an interest rate strategist at TD
Securities in New York.
The sell-off also reflects the high premium that TIPS bonds
have afforded over the past few years, where investors accepted
negative yields, after accounting for inflation, expecting that
the lost returns would be made up for by rising inflation.
TIPS principal increases when consumer prices rise. Based on
the rise in principal, the interest paid also increases. Falling
inflation expectations makes these bonds less attractive.
The sell-off may be creating opportunities in shorter-dated
TIPS as investors have begun pricing in lower inflation than may
be likely in the near-term. Two-year TIPS breakevens, for
example, have dropped to 87 basis points, said Taylor.
"If over the next two years you think inflation will be
north of 1 percent, you are much better off with a two-year TIPS
than a two-year Treasury," said Taylor.