Bonds Show Inflation Peaks as Slow Growth Deflates Commodities

By Anchalee Worrachate and Theresa Barraclough

Aug. 11 (Bloomberg) -- Schroder Investment Management's David Scammell is so convinced inflation has crested that the bond fund manager this quarter has sold securities designed to protect from rising consumer prices.

The money manager, who in the first half of the year bought all the so-called index-linked bonds he could find as crude oil rose above $100 a barrel, says the global economy has become too weak to sustain a rally in commodities, capping inflation.

``We've been reducing index-linked bond holdings,'' said Scammell, whose firm is a unit of the U.K.'s largest publicly traded money manager. ``Central bankers have to maintain their hawkish tone because they need to anchor inflation expectations, but the reality is we are seeing a spell of weak data.''

Scammell is no lonely voice. A survey out today of 25 bond fund managers controlling $1.41 trillion of assets by Jersey City, New Jersey-based Ried, Thunberg & Co. found that 79 percent expect inflation ``to moderate late this year into 2009.''

Since June returns on government debt linked to consumer prices shrunk to 0.8 percent from 4 percent in the first half of the year, according to indexes compiled by New York-based Merrill Lynch & Co. At the same time, regular bonds gained 1.9 percent, after returning 0.1 percent in the first six months.

Economic `Downdraft'

European Central Bank President Jean-Claude Trichet said Aug. 7 that the region's economy will be ``particularly weak'' through the third quarter. The Federal Reserve said Aug. 5 that a shrinking labor market and financial-market strains will hinder U.S. growth. Japan's government said Aug. 6 the economy is ``deteriorating,'' acknowledging for the first time that the country's longest postwar expansion has probably ended.

The odds are ``over 60 percent'' that the U.S. economy, the world's largest, will enter a recession and any recovery will likely be shallow and lengthy, Henry Kaufman, the former Salomon Brothers chief economist, said last week.

``We are in a downdraft,'' Kaufman, who has followed Wall Street for five decades and is president of his own investment management firm, said in an interview with Bloomberg Television.

At the same time growth is weakening, prices of commodities, which rose an average of 47 percent in the 12 months ended June 30 as measured by the Reuters/Jefferies CRB Index of 19 raw materials, are starting to retreat. The index fell 12 percent over the past month, easing concerns about inflation.

`Close to the Peak'

``We are probably getting close to the peak in inflation in the short term,'' said Brian Weinstein, who manages $9 billion in inflation bonds at New York-based BlackRock Inc. The firm is the largest publicly traded fund manager in the U.S., overseeing $1.43 trillion in assets.

Weinstein said he is shifting out of shorter-maturity U.S. Treasury Inflation-Protected Securities, or TIPS, into longer- dated ones, a sign that he doesn't expect a rise in consumer prices as being an imminent threat. The U.S. may say Aug. 14 that consumer prices rose 0.4 percent in July, compared with 1.1 percent in May, according to the median estimate of 52 economists surveyed by Bloomberg.

The difference in yields on 10-year TIPS and regular bonds narrowed in July by the most since 2003, according to data compiled by Bloomberg. The so-called breakeven rate, which represents the rate of inflation investors expect over the life of the securities, fell to 2.23 percentage points last week from the peak this year of 2.6 percentage points on July 4.

`Faded' Bonds

``The slowing economic environment which we are seeing in Europe and in the U.S. will help moderate inflation,'' said William Chepolis, who oversees $9 billion of bonds as a fixed- income fund manager at DWS Investments in New York.

Chepolis, who said he favored TIPS earlier this year, ``faded'' the securities in July by buying regular bonds instead of the securities with new cash that flowed into his fund. He said TIPS are now ``fairly priced.''

In Europe, index-linked bonds, or linkers, were poised for their worst third-quarter performance in almost 10 years, returning 0.94 percent as of last week, Merrill Lynch data shows. The 10-year breakeven rate in Japan narrowed to 22 basis points after reaching a 12-month high of 59 basis points on July 7.

Investors are shunning index-linked securities even as global inflation accelerates at the fastest pace in a decade. The U.S. consumer-price index rose 5 percent in June from a year earlier, the most since 1991.

In the euro region, the inflation rate rose to 4.1 percent in July, the highest since April 1992, and more than doubling the ECB's threshold of 2 percent. In Japan, prices excluding fresh food climbed 1.9 percent in June, the most in a decade.

World Bank Outlook

``The biggest story in the bond market in the next six to 12 months is going to be a slowdown in global growth,'' BlackRock's Weinstein said. ``There'll be realization that the housing crisis-led slowdown in the U.S. has led to a credit problem worldwide.''

The World Bank, a Washington-based lender to nations, said on June 10 that global economic growth will probably slow to 2.7 percent this year from 3.7 percent in 2007.

The Basel-based Bank of International Settlements, a bank for central banks, said in June the economy may be headed for a slump so severe that it brings a drop in general price levels in the U.S. and U.K. Deflation may soon become the biggest risk to the world economy, Albert Edwards, the London-based global strategist at Societe Generale SA who predicted the Asian currency crisis a decade ago, said in an interview last month.

As recently as 2003 the Fed cut its target rate for overnight loans between banks to a 45-year low of 1 percent because it was concerned about disinflation. Japan's government has yet to declare that the economy has escaped from a bout of deflation which emerged after an asset-price bubble burst in the early 1990s.

``Inflationary pressure is abating while deflationary pressure is emerging,'' said Akira Takei, the general manager for international bonds at Mizuho Asset Management Co., in Tokyo, which oversees the equivalent of $37.3 billion. ``I believe that the U.S. economy will go into deflation eventually. It's better to prefer conventional bonds rather than TIPS.''

To contact the reporters on this story: Anchalee Worrachate in London at aworrachate@bloomberg.net; Theresa Barraclough in Tokyo at tbarraclough@bloomberg.net;