TIPS Show Inflation Expectations at Lowest Level in Five Years

By Dakin Campbell

Aug. 9 (Bloomberg) -- Treasury Inflation Protected Securities show that traders' expectations for inflation over the next decade fell to the lowest in almost five years this week as prices of commodities tumbled.

The gap between yields on TIPS and conventional 10-year notes narrowed after the Federal Reserve signaled that it will keep borrowing costs steady after leaving interest rates unchanged at its Aug. 5 policy meeting. A basket of 19 commodities including oil fell to a four-month low.

``The bottom line is you've seen a significant turn in commodity prices,'' said Thomas Tucci, head of U.S. government bond trading at RBC Capital Markets in New York, the investment- banking arm of Canada's biggest lender. ``Going forward you're more likely to see inflation erode.''

Ten-year TIPS yielded 2.18 percentage points less than similar-maturity notes, the smallest difference since October 2003. The yield gap indicates the annual rate of inflation foreseen over the life of the security.

The yield on the benchmark 10-year Treasury was little changed last week at 3.94 percent, according to BGCantor Market Data. The 4 percent security due in August 2018 traded at 100 15/32. The two-year note's yield increased 1 basis point, or 0.01 percentage point, to 2.50 percent on the week.

Yields on 30-year bonds decreased 3 basis points for the week to 4.52 percent as the securities, more sensitive to inflation than shorter-term debt, outperformed notes.

Consumer Price Report

Oil fell for the fourth week in five, leading the Reuters/Jefferies CRB Index, a basket of 19 raw materials, to a four-month low. Crude traded on the New York Mercantile Exchange for September delivery fell 8 percent this week to $115.20 a barrel.

The government on Aug. 14 will likely say that consumer prices including food and energy rose 0.4 percent last month, after a 1.1 percent increase in June, according to the median forecast in a Bloomberg News survey of 52 economists. That would be the smallest monthly increase since April.

If ``I am with the Fed right now, I feel pretty good about my statement that we expect inflation to moderate over time,'' Brian Edmonds, head of interest rates at Cantor Fitzgerald LP, said Aug. 5. Cantor is one of 19 primary dealers that trade with the U.S. central bank.

Fed policy makers left the benchmark rate for overnight lending between banks unchanged at 2 percent on Aug. 5 for a second straight policy meeting, saying inflation is a significant concern while risks to growth remain. The central bank reduced interest rates by 3.25 percentage points in a series of seven cuts between September and April.

Inflation Bet

``The Fed is making a bet inflation is going to take care of itself over the next six months,'' E. Craig Coats Jr., co- head of fixed income at Keefe, Bruyette & Woods Inc. in New York, said after the central bank's meeting.

Traders increased bets the Fed won't raise the target rate through the end of the year. They saw a 62 percent chance yesterday that the central bank will hold the rate steady through December, compared with 35 percent odds a week earlier, according to futures contracts on the Chicago Board of Trade.

Auctions of 10- and 30-year Treasuries this week drew better-than-forecast demand, showing investors are still attracted to the safety of U.S. government debt.

The sale of $10 billion in 30-year bonds attracted the most participation in two-and-a-half years from a class of investors that includes foreign central banks. The group, known as indirect bidders, bought 42.9 percent of the auction, the most since February 2006. The sale, the biggest of the maturity since 2006, drew a yield of 4.609 percent, below the 4.662 percent average forecast of nine bond-trading firms surveyed by Bloomberg News.

`Fear and Uncertainty'

``The auction went much better than anyone expected,'' Nils Overdahl, a portfolio manager in Bethesda, Maryland, at New Century Advisors, said on Aug. 7. He helps manage $500 million in assets. ``There's still a great deal of fear and uncertainty in the market. People are happy to hold onto the safety of Treasuries.''

A sale of $17 billion in 10-year notes, the most in five years, drew a yield of 4.075 percent, lower than the 4.101 percent forecast by six bond-trading firms in another Bloomberg survey. Investors bid for 2.61 times the amount offered, the strongest so-called bid-to-cover ratio since September.

Speculation eased that the European Central Bank, whose sole mandate is to maintain price stability, will raise interest rates. The ECB held its benchmark rate at 4.25 percent at its policy meeting this week. Its president, Jean-Claude Trichet, said expansion will be ``particularly weak'' in the second and third quarters.

To contact the reporter on this story: Dakin Campbell in New York at dcampbell27@bloomberg.net