Bond Market and Fed Are on Same Page About U.S. Inflation Pickup

(Bloomberg) -- Bond traders and Federal Reserve officials are on the same page about the prospect for U.S. inflation to accelerate.

Gauges of the Treasury yield curve rose to the steepest since June and market-based measures of inflation expectations held near the highest in 16 months as traders bet the Fed will raise interest rates next month. Policy makers, in leaving their benchmark rate unchanged Wednesday, upgraded their inflation assessment, acknowledging that the pace of price increases “has increased somewhat since earlier this year.”

The Fed's nod to price growth, combined with expectations that Friday's October employment report will show a pickup from the prior month, is boosting bond traders' confidence that the central bank is close to its dual mandate and will raise rates before year-end. They're assigning a 78 percent probability to a hike next month, compared with less than 70 percent earlier in the week.

“The Fed is encouraged by the recent numbers of growth and inflation,” John Bellows, a portfolio manager at Western Asset Management, said in an interview on Bloomberg Television. Policy makers are “adjusting accordingly, so that's put them more or less on track for a December hike.”

Treasury 10-year note yields rose about one basis point, or 0.01 percentage point, to 1.81 percent at 5 p.m. in New York, according to Bloomberg Bond Trader data. The 1.5 percent security due in August 2026 fell 2/32, or $0.63 per $1,000 face amount, to 97 7/32.

Break-Even Rate

Yields on U.S. 30-year bonds climbed three basis points to 2.6 percent, while those on five-year notes were little changed at 1.26 percent. The spread between the two maturities increased to about 1.33 percentage points, the widest closing level since June 24. That means longer-dated bonds, which are more sensitive to inflation expectations, are experiencing a bigger selloff.

At the same time, the yield spread between 10-year Treasury bonds and similar-maturity Treasury Inflation Protected Securities, or TIPS, climbed to 1.74 percentage points earlier this week, the highest since July 2015 on a closing basis. Known as the break-even rate, the measure shows investor expectations for average annual consumer-price gains over the period.

The Fed's preferred gauge of price pressures has moved closer to the bank's 2 percent target this year, reaching 1.7 percent in the 12 months through September after stripping out volatile food and energy components. 

“There does appear to have been a more explicit reference to the possibility that inflation may be getting a little bit of steam now, so that might tend to reinforce the view that we are going to have a rate increase in December,” former Richmond Fed President Al Broaddus said Wednesday in an interview on Bloomberg Television.

Investors seem to agree with the inflation outlook. Weekly inflows into the iShares TIPS Bond exchange-traded fund reached their highest level on record as investors brace for the possibility of a sustained upturn in price pressures. Cumulative weekly additions are more than $972 million, the highest of any U.S. fixed-income ETF over this period.

Unemployment was 5 percent in September, at or close to what many economists estimate is its lowest sustainable level. U.S. nonfarm payrolls probably climbed by 173,000 last month, according to the median forecast in a Bloomberg survey of economists. Average hourly earnings are forecast to rise by 2.6 percent from a year earlier. The Labor Department will release those figures on Friday.

--With assistance from Luke Kawa To contact the reporter on this story: Brian Chappatta in New York at bchappatta1@bloomberg.net. To contact the editors responsible for this story: Boris Korby at bkorby1@bloomberg.net, Michael Aneiro