One industry's boom is proving to be the government's next meal ticket

Structural Inflation

Yields on 10-year Treasuries will climb to 3.45% by the end of 2014, according to the median forecast of 69 economists in a Bloomberg survey.

A stronger U.S. economy will spur consumer demand that lifts prices more consistently as wages increase, which may offset declines in energy costs and erode the appeal of Treasuries, according to Ira Jersey, a New York-based interest-rate strategist at Credit Suisse Group AG.

“Wage inflation tends to be more structural and tends to last longer,” Jersey of Credit Suisse, one of 21 primary dealers that are obliged to bid at U.S. government debt auctions, said in a Jan. 14 telephone interview.

The world’s largest economy will expand 2.8% this year and accelerate 3% in 2015, which would be the fastest in a decade, based on economists surveyed by Bloomberg.

The Fed, which has flooded the economy with more than $3 trillion to stimulate growth, will cut monthly purchases of Treasuries and mortgage-backed securities to $75 billion from $85 billion this month.

OPEC Dollars

The bank will then reduce buying by $10 billion in each of the next six meetings before ending its stimulus in December, according to 42 economists surveyed by Bloomberg in January.

Higher U.S. oil output is also leaving the Organization of Petroleum Exporting Countries with fewer dollars to invest in Treasuries. OPEC nations are on track to hold fewer Treasuries at the end of 2013 than the start, which would be the first annual decline since 2003. OPEC members held $236.2 billion of Treasuries at the end of November, 9.8% less than at the end of 2012, government data show.

Nevertheless, spending fewer dollars abroad to buy crude oil means the U.S. currency is no longer depreciating as demand for crude rises, which may ultimately help preserve the value of Treasuries for foreign creditors. They hold almost half of the nation’s $11.8 trillion in marketable debt obligations as of November, with China and Japan together owning $2.5 trillion.

Over the past decade, the dollar has usually weakened whenever crude rose. That relationship broke down last month, according to data compiled by Bloomberg.

Feedback Loop

The 120-day correlation between the two assets, which has averaged minus 0.3 over the past 10 years, turned positive in December before climbing to 0.033, which was the highest since February 2003, data show.

A reading of minus 1 means two securities always move in opposite directions, 0 means their moves aren’t related at all and 1 indicates that they always move in the same direction.

In July 2008, when oil reached a record $145.29 a barrel, the dollar traded at $1.57 per euro, within three cents of its record low. The same month, U.S. consumer prices also rose by the most in 17 years, surging 5.6% from a year earlier.

“There can certainly be a very positive circular feedback loop,” said Alan Ruskin, the New York-based global head of Group of 10 foreign-exchange at Deutsche Bank AG, the world’s largest currency trader, in a Jan. 16 telephone interview.

This year, the dollar is forecast to appreciate to $1.28 per euro from a current $1.3530 and to 110 yen from 104.72, according to Bloomberg surveys.

History Lesson

America has pursued energy self-sufficiency ever since Arab producers declared an oil embargo in the autumn of 1973 to retaliate against the U.S. government for assisting Israel during the Yom Kippur War. The energy crisis caused chronic fuel shortages in the U.S. that ignited inflation and pushed the economy into a recession, becoming a precursor to a phenomenon known as stagflation which emerged later in the decade.

America’s borrowing costs soared as investors demanded more compensation to hold U.S. government debt, with yields on 10- year Treasuries eclipsing 8% in 1974. An inflation rate of 12.34% that year meant that holders of Treasuries were left with a loss of about 5.3% in real terms, according to data compiled by Barclays Plc.

Now, the U.S. is on the verge of surpassing Russia and Saudi Arabia as the world’s largest producer of oil, according to the International Energy Agency.

“You deserve a stronger currency, stronger financial markets, a better role within the global financial system because you are not dependent” on imported oil, Brandywine’s McIntyre said.

www.bloomberg.com

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