You Missed $1 Trillion Return If You Agreed With Fed Naysayers

Gold Bug

The slowdown in cost-of-living increases upended billionaire John Paulson, who began amassing gold in 2009 in anticipation the Fed’s extraordinary debt purchases would cause “very high rates of inflation.”

While Paulson & Co., his New York-based hedge fund, made $15 billion in 2007 betting on the collapse of the U.S. housing market, Paulson told clients in November that he personally wouldn’t invest more money in gold as the bullion suffered its biggest annual loss in three decades last year. Paulson didn’t respond to telephone calls or e-mail messages seeking comment.

“The market has learned the lesson that if the Fed wants to keep rates low, it has the tools to do so,” Tanweer Akram, a senior economist at Voya Investment Management, which oversees $213 billion, said in a Sept. 3 telephone interview from Atlanta. “And it’s done it without sparking inflation.”

Now, as the Fed moves to end its latest round of bond buying and considers increasing rates, the debate over the pace of tightening has never been more important.

Purchasing Power

One of the biggest reasons bond investors are so confident that the Fed won’t need to move aggressively to boost rates and trigger a bond-market selloff is because sustained improvement in the U.S. labor market remains elusive.

Employers added just 142,000 jobs last month, according to a Labor Department report, the fewest this year and below even the most pessimistic estimate in a Bloomberg survey. The latest payrolls data halted a six-month streak of employment gains surpassing 200,000, which was the most since 1997.

On an annual basis, growth in hourly earnings in the past five years has been the weakest over the course of any expansion since at least the 1960s, data compiled by Bloomberg show.

Without more jobs and higher wages, there’s little chance Americans will spend enough to spur faster inflation.

Based on bond trading, investors anticipate living expenses to increase an average 1.85 percent over the next five years, in line with the mean since 2009. As recently as March last year, inflation expectations were as high as 2.42 percent.

Less inflation makes fixed income more attractive and means investors can earn more in real terms even as yields fall.

Vigilantes Wanted

Demand for 10-year Treasurys has pushed down yields more than a half-percentage point in 2014 to 2.47 percent today.

“Inflation is in check,” Dan Heckman, a senior fixed- income strategist at U.S. Bank Wealth Management, which oversees $120 billion, said by phone from Kansas City, Missouri, on Sept. 3. That’s “helping keep a cap on Treasurys.”

While inflation hasn’t yet emerged as a problem, investors need to be more vigilant of the possibility the Fed is getting it all wrong, according to John Brynjolfsson, the chief investment officer at Irvine, California-based hedge fund Armored Wolf LLC, which manages $670 million.

“Given the magnitude of the easing, there is a lot of kindling to catch fire when inflation arises and the Fed is more likely to be behind the curve in fighting it,” Brynjolfsson, who ran Pacific Investment Management Co.’s first inflation- linked fund, said by telephone Sept. 5. “Buying Treasurys is like picking up pennies in front of a steamroller.”

‘More Disruptive’

Even as hiring in the U.S. slowed last month, reports from manufacturing to auto sales and construction all suggest the economy is gaining momentum. Economists anticipate 3 percent growth next year, which would be the fastest in a decade, according to data compiled by Bloomberg.

Stan Druckenmiller, the hedge-fund manager with one of the best track records in the past three decades, said in July the Fed’s policy of keeping rates near zero for so long is baffling and risky while the odds are high its “monetary experiment will be more disruptive down the road than the Fed anticipates.”

Some Fed officials have started to reassess their own views on how long the target rate needs to stay between zero and 0.25 percent. Minutes of the central bank’s July meeting released on Aug. 20 showed “many” participants said the Fed might raise borrowing costs sooner than they had expected.

Last month, Philadelphia Fed President Charles Plosser said waiting too long to increase rates risks spurring inflation.

Blowing Smoke

While Yellen faces more pressure within the Fed after Plosser dissented at the central bank’s latest meeting, the bond market is still signaling that policy makers won’t need to boost rates much before stopping.

Traders anticipate the benchmark rate will rise to 0.7 percent by the end of next year, less than the median estimate of 1.13 percent from Fed officials. Meanwhile, the one-year interest-rate swap traded five years forward, a proxy for where rates may peak, fell to 3.17 percent.

That compares with 4.24 percent at the start of 2014, which was close to the historical average for peak interest rates that New York Fed President William Dudley said would be consistent with the central bank’s current target for inflation.

“We aren’t seeing the type of growth that will spur inflation,” Guy Lebas, the Philadelphia-based chief fixed- income strategist at Janney Montgomery Scott LLC, which oversees $61 billion, said by telephone on Sept. 3. “The smoke tendrils of inflation that have popped up from time to time have turned out to be a false alarm.”