Inflation evident as ETF flows converge with investor choices

The Federal Reserve’s attempt to lift inflation to a level that would reflect a healthier U.S. economy is starting to take hold in the bond (CBOT:USM13) market.

For the first time in 19 months, investors are stepping up their buying of exchange-traded funds that hold Treasuries tied to cost-of-living increases, data compiled by Bloomberg show. At the same time, inflation expectations over the next five years surpassed 2% to reach the highest level since May after a government report showed hourly earnings among U.S. workers jumped more on average in February than economists forecast.

The shift in bond-market perceptions shows that some investors now anticipate consumer demand in the world’s largest economy will be strong enough to push inflation toward the Fed’s elusive 2% target. Last year, investors were so convinced the persistent lack of price pressure had become entrenched that Treasury Inflation Protected Securities, or TIPS, posted their worst losses since they were introduced in 1997.

“Inflation is coming,” Michael Pond, the head of global inflation-linked research at Barclays Plc, one of the 22 primary dealers that trade with the Fed, said in a telephone interview from New York. We’re starting to break “free from some of the deflationary shackles of last year. The labor market is picking up, which will cause wages to pick up.”

While a recovery in consumer spending would validate the Fed’s move to scale back its quantitative easing after flooding the U.S. economy with more than $3 trillion since the financial crisis, the risk of inflation has prompted some investors to favor TIPS over Treasuries that pay a fixed rate of interest.

Purchasing Power

Unlike Treasuries, whose fixed payments lose value as living costs increase, TIPS appreciate. The securities returned 2.75% this year, rebounding from a 9.4% plunge in 2013 and outperforming the broader market for U.S. government debt, index data compiled by Bank of America Merrill Lynch show.

Many investors have been overly optimistic “inflation will stay relatively contained and that the Fed will make a graceful exit from QE,” Zach Pandl, a senior interest-rate strategist at Columbia Management Investment Advisers, which oversees $340 billion, said by telephone from Minneapolis. “The economy has made a lot of progress and is accelerating.”

Pandl, who is avoiding Treasuries because of the likelihood the economy will strengthen, is buying TIPS. Yields on the benchmark 10-year TIPS have fallen 0.31 percentage point this year to 0.49%, while those on similar-maturity Treasuries have declined to 2.68% from a more than two-year high of 3.03% on Dec. 31.

Consumer Spending

Net purchases of the 12 ETFs that hold U.S. inflation- linked bonds have totaled $399 million in March, the first time combined inflows have surpassed redemptions from the funds since August 2012, data compiled by Bloomberg show.

The largest such ETF, the $13 billion iShares TIPS ETF run by BlackRock Inc., is poised to snap its longest streak of withdrawals since its inception a decade ago with the biggest monthly net increase in two years, the data show.

Inflation expectations have picked up on signs that wage growth will lead to more consumer spending. The gap between yields on five-year Treasuries and similar-maturity TIPS widened to a 10-month high on March 7, implying that consumer prices will rise an average 2.01% over that span.

As recently as June, the break-even inflation rate was 1.63%, the lowest since January 2012. It was at 1.95% as of 10:30 a.m. in New York.

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