The Old Nemesis Is Starting To Spook Bond Traders Again

Three months ago, bond traders were bracing for deflation in the U.S.

Now, they’re starting to worry about inflation -- and snapping up a record share of Treasuries that offer some protection.

So what’s changed? Part of the answer, of course, has to do with oil, which arrested what seemed like an unrelenting slide that pushed prices from more than $100 a barrel to less than $50 in a span of five months.

But perhaps just as important is the bond market’s changing perception of the Federal Reserve. Instead of worrying about how the Fed’s zeal to roll back its policy of holding interest rates near zero might choke off growth, bond traders are now confident the central bank will let the economy regain the momentum it lost with oil’s plunge before raising borrowing costs.

“We’ve been through the negative impact” of oil, said James Evans, a New York-based money manager at Brown Brothers Harriman & Co., which oversees about $15 billion. “And the Fed is still going to be very cautious about raising rates. The foundation is there for higher inflation.”

Evans said he’s been buying Treasury Inflation Protected Securities, or TIPS, due in five to 10 years.

He’s among a growing number who are embracing the inflation story. Trading in the securities as a percentage of total Treasuries volume reached an all-time high of about 2.75 percent this month, Fed data tracked by Barclays Plc shows.

Bond Shift

Investors have also purchased 72 percent of the TIPS auctioned by the Treasury Department this year, the greatest proportion since at least 2003.

Increased demand for inflation protection has coincided with an upturn in the bond market’s expectations for how much consumer prices will rise in coming years. Faster inflation erodes the buying power of fixed-rate payments of bonds.

Based on a metric known as the break-even rate, traders see inflation averaging 1.71 percent a year in the next half-decade. That’s a half-percentage point higher than at the end of 2014 and the biggest jump over a comparable period in four years.

“Headwinds on inflation are abating,” said Michael Pond, the head of inflation-linked research at Barclays in New York.

It’s a stark contrast to the state of affairs at the start of 2015, when the free fall in oil and other commodities raised the specter of a global deflationary spiral and pushed central banks from Europe to China to act and stimulate demand.