Inflation fears mount
By Michael Mackenzie in New York
April 12, 2007

Bond market expectations of future inflation have risen to their highest level in seven months, boosting demand for Treasuries that protect investors against increases in consumer prices.

Investors will get a chance to buy $6bn in 10-year inflation-linked Treasury bonds, known as Tips, at an auction on Thursday, and strong demand is expected, particularly as investors originally expected a sale of about $8bn.

"We are nervous about inflation," said David Ader, bond strategist at RBS Greenwich Capital. He said the smaller auction and the seasonal tendency for inflation to rise in March supported demand for Tips.

Tips protect investors against inflation by adding principal as consumer prices rise. As inflation expectations increase, investors become more willing to pay higher prices for such bonds and accept lower yields.

The difference between the yields on standard 10-year Treasury bonds and 10-year Tips, known as the break-even rate, is a proxy for market expectations of average annual consumer price inflation. The greater the difference, the higher the inflation expectation.

This indicator has been rising to nearly 2.5 per cent in recent weeks, up from less than 2.3 per cent at the start of this year.

TJ Marta, fixed-income strategist at RBC Capital Markets, said higher break-even rates reflected higher oil prices and the Federal Reserve's statement edging away from its inflation-fighting bias towards a more neutral stance at its policy meeting last month.

Analysts also see a tight US labour market and rising base-metal prices as potential drivers of inflation.

Investors and policymakers watch the 10-year break-even rate closely. At the moment, the measure is still below last May's peak of 2.73 per cent.

Currently, personal consumption expenditure inflation excluding fuel and energy prices – the Fed's preferred measure of inflation – is running at 2.4 per cent a year. That is above the 1 per cent to 2 per cent range believed to be the central bank's comfort zone.

Ben Bernanke, Fed chairman, recently told Congress that the Fed retained an inflation-fighting bias. But analysts say weakening economic growth could lead the Fed to cut interest rates, potentially stoking inflation.

They add that the prospect of a rate cut by the Fed with core inflation already above 2 per cent would probably increase market expectations of future rates.

"The Fed will cut quickly if the economy weakens sharply and in spite of core inflation remaining elevated," said Gerald Lucas, investment adviser at Deutsche Bank.
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