TIPS show inflation alarm fading as options give Fed time

Federal Reserve Building Federal Reserve Building

Bill Gross, who runs the world’s biggest bond fund, says the Federal Reserve’s open-ended plan to flood the economy with $40 billion a month will ignite inflation. The options market is signaling that won’t happen anytime soon.

Demand to protect against higher long-term bond yields over the next six months has been static since Fed Chairman Ben S. Bernanke announced a third round of quantitative easing, or QE3, Sept. 13, Barclays Plc data shows. Appetite, though, is rising for options that mature in 2015. Traders’ expectations for consumer price increases as measured by inflation-protected Treasuries have fallen from highest levels since 2006.

The market measures show tame inflation is giving Bernanke time to nurse the economy back from the depths of the worst financial crisis since the Great Depression without pressure to withdraw stimulus just as $1.2 trillion in mandated fiscal spending cuts and tax increases start Jan. 1. Consumer prices are in check though the Fed pumped $2.3 trillion into the economy through QE bond purchases since 2008.

“The market is not suggesting there’s any kind of runaway inflation in the next one or two years given the below trend growth trajectory and the impending fiscal cliff,” said Gemma Wright-Casparius, who manages the $43.9 billion Vanguard Inflation-Protected Securities Fund at Valley Forge, Pennsylvania-based Vanguard Group Inc.

Bond Rally

Treasuries have returned 41 percent since mid-2007 when including reinvested interest, according to Bank of America Merrill Lynch indexes. That’s better than the 7.52 percent gain for the Standard & Poor’s 500 with dividends.

Yields on 10-year notes fell 12 basis points last week, or 0.12 percentage point, to 1.64 percent in New York, according to Bloomberg Bond Trader prices. The price of the benchmark 1.625 percent security due August 2022 rose 1 2/32, or $10.63 per $1,000 face amount, to 99 29/32. The yield was 1.63 percent at 9:31 a.m. New York time.

Even as speculation mounted in recent months that the Fed would undertake a third round of QE, a policy that risks igniting inflation by debasing the dollar and assets denominated in the currency, economists and strategists have grown more bullish on bonds.

The median of 78 estimates is for 10-year yields to end the year at 1.75 percent, and finish 2013 at 2.4 percent. In April, the survey estimated yields at 3 percent by the start of 2014, still below the average of about 7 percent since 1970. Yields are down about 0.25 percentage point this year.

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