US inflation expectations boost Tips demand

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US inflation expectations for the next five years rose to their highest level in seven months on Monday, as investors believe the inflation-linked bond market is underplaying a prospective pick up in consumer price pressures.

Expectations for inflation over the next five years, as measured by comparing yields on Treasury inflation protected securities and nominal Treasury bonds, rose to 1.97 per cent on Monday, and are up from 1.8 per cent since the start of the year.

Traders say demand for five-year Tips from Asia and institutional investors has been solid, with the market looking for inflation to rise above 2 per cent during the next five years.

Tips generally outperform nominal bonds when inflation averages more than the expected, or break-even, rate.

Also playing a role is the fact that US oil and petrol prices have been rising this year, boosting demand for shorter dated Tips.

“A break-even rate below 2 per cent looks pretty attractive for investors,” said James Evans, senior vice-president at Brown Brothers Harriman. He said five-year break-even inflation rates look to have scope to rise towards 2.25 per cent.

The five-year break-even rate has not been above 2 per cent since last August.

Richard Gilhooly, strategist at TD Securities, said: “We stick to our existing view that five-year break-evens are underpriced.” He said a move above 2 per cent should “kick-start momentum” towards 2.25 per cent for five-year break-evens.

Driving demand for five-year Tips is their so-called “positive carry” trade status, whereby the monthly inflation accretion earned during March is higher than the cost of financing the trade through the repurchase market.

“Positive carry started on Saturday and we expect February and March consumer price index estimates to move higher,” said Mr Gilhooly.

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