Conquer the crash: Bernanke defeats deflation.


At last, the news reports are now fully brimming with optimism and proclaiming victory after victory on the economic front. Despite the fact that the private (and total) credit in the US economy has been and is still contracting at unprecedented multitrillion dollar annual rate, which is deflation by definition in credit based monetary system, the Bloomberg news declares nevertheless that the honorable manager of the privately owned Federal Reserve, Ben Bernanke, has already defeated deflation. Oh say, can you see …

Bloomberg. December 21, 2009.

TIPS Give Way to Inflation as Deflation Yields Drop.

Dec. 21 (Bloomberg) — The market for Treasury inflation protected securities is showing Federal Reserve Chairman Ben S. Bernanke won the battle with deflation, paving the way for him to start withdrawing cash pumped into the economy since 2007.

The gap between yields on Treasuries and so-called TIPS due in 10 years, a measure of the outlook for consumer prices, closed above 2.25 percentage points four days last week, the longest stretch since August 2008. That’s the low end of the range in the five years before Lehman Brothers Holdings Inc. collapsed, and shows traders expect inflation, not deflation in coming months, said Jay Moskowitz, head of TIPS trading at CRT Capital Group LLC in Stamford, Connecticut.

Bernanke has cited tame inflation expectations for keeping the target interest rate for overnight loans between banks at a record low range of zero to 0.25 percent and the unprecedented stimulus that prevented more bank failures during the worst financial crisis since the Great Depression. Now, TIPS show the improving economy may change sentiment and spark further losses in bonds. Yields on the benchmark 10-year Treasury note hit a four-month high of 3.62 percent last week.

“It could be an environment where we see 4 percent on 10- year yields, which we think is probably likely in the near term,” said Carl Lantz, an interest-rate strategist in New York at Credit Suisse Securities Group AG, one of the 18 primary dealers of U.S. government securities that trade with the Fed.

Rising Yields

The yield on the benchmark 3.375 percent note due November 2019 rose 14 basis points to 3.67 percent at 2:50 p.m. in New York, according to BGCantor Market Data.

Treasuries are poised for their first down year in a decade, losing 2.43 percent after reinvested interest, according to Merrill Lynch & Co.’s U.S. Treasury Master index. They gained 14 percent on average in 2008 as the global recession deepened and investors bet on deflation, or a general decline in prices.

While prices fell, real yields, which takes into account inflation or deflation, widened to an average of 3.64 percent this year, the most since 1998, helping attract investors to the record $1.48 trillion in new cash raised by the government in the bond market in 2009.

TIPS returned 11.1 percent this year as measured by Merrill Lynch indexes, on speculation that the almost $12 trillion lent, spent or committed by the government and Fed to keep financial markets from collapsing would spark inflation.

‘Deflation Fighter’

“The TIPS breakevens moving higher is a sign Bernanke is gaining credibility as a deflation fighter,” said Robert Tipp, chief investment strategist for fixed income at Prudential Investment Management. The Newark, New Jersey-based firm oversees more than $200 billion in bonds.

The securities pay interest on a principal amount that rises or falls based on the consumer price index. Inflation- protected bonds due in 10 years yield 2.34 percentage points less than Treasuries. That gap, known as the break-even rate, has risen from 0.04 percent in November 2008. It averaged about 2.42 percentage points in the five year’s before Lehman went bankrupt.

“A lot of people are investing in the asset class viewing that with the amount of liquidity that the Fed has provided the market and the devaluation of the dollar that inflation’s inevitable somewhere down the road,” said Todd White, who oversees government debt trading at Minneapolis-based RiverSource Investments, which manages $93 billion of bonds. The breakeven rate could widen to 2.75 percentage points, he said.

Fed Statement

The last time the difference was that wide was May 2006, when the Fed’s target rate was 5 percent.

After their meeting in Washington on Dec. 16, Fed policy makers said in a statement that keeping borrowing costs low is contingent on “low rates of resource utilization, subdued inflation trends, and stable inflation expectations.”

That day, the Labor Department said its consumer price index rose 0.4 percent in November, matching the second biggest gain of the past year. The day before, the government said wholesale prices surged 1.8 percent, more than twice the 0.8 percent median forecast of economists surveyed by Bloomberg.

With market functions improving, the central bank also said that most of its special liquidity facilities will expire on Feb. 1, including programs to backstop money-market mutual funds and commercial paper. The Fed said it’s working with other central banks to close temporary liquidity swap arrangements by then.

‘Unmoored’ Expectations

Prices of federal-funds futures contracts on the Chicago Board of Trade show a 42 percent chance policy makers will lift rates by mid-2010, up from 34 percent a month ago. The median estimate of 63 economists and strategists surveyed by Bloomberg is for 10-year yields to rise to 3.68 percent in the same period.

“What could get them to move is if inflation expectations become unmoored,” said Michael Pond, an interest-rate strategist in New York at Barclays Plc, the largest trader of U.S. inflation-linked debt and a primary dealer.

With the unemployment rate at 10 percent, TIPS breakeven rates may be overstating the potential for rising consumer prices, according to Ken Volpert, a money manager at Valley Forge, Pennsylvania-based Vanguard Group Inc.

“We’re going to have inflation that in the next year is below what’s implied in the breakevens,” said Volpert, who oversees $180 billion in taxable bonds.

Fed Forecast

The Fed’s long-term forecast for its preferred measure of inflation, the Commerce Department index tied to consumer spending and excluding food and fuel, is 1.8 percent to 2 percent. That gauge, which is typically lower than the CPI, was up 1.4 percent in the 12 months to October.

Deflation can menace an economy just as much as inflation because it discourages investment and spending. Japan’s economy has been in and out of recession since the mid-1990s, largely because of falling consumer prices.

San Ramon, California-based Chevron Corp., the second- largest U.S. energy producer, said Dec. 10 that it cut its 2010 capital plan by 5 percent. Capacity utilization, which measures the proportion of plants in use, was 71.3 percent last month, down from 80.5 percent at the start of 2008, the Fed said last week.

Other parts of the bond market are signaling that prices will increase. The Fed’s five-year/five-year forward breakeven rate rose to 3.13 percentage points last week from 2.04 percentage points a year ago. The rate plots forward rates measuring investor expectations for inflation in five years.

Pre-Crisis High

The gauge is approaching the pre-financial crisis high of 3.36 percent in May 2004, a month before the central bank began a series of 17-consecutive rate increases that brought its target to 5.25 percent in June 2006 from 1 percent.

What’s changed from last year is that commodities are on the rise. Oil fell as low as $32.40 a barrel a year ago as the economy contracted. It rebounded to as high as $82 in October, before ending last week at $74. Gold has risen 39 percent to a record $1,226.40 an ounce on Dec. 3.

“Over the course of the year we’ve pretty much moved back to the historical range in five-year/five-year,” said Credit Suisse’s Lantz. “We are testing the upper end of that range and I think that’s associated with concerns about the long-term inflation outlook, given the Fed’s very accommodative policy stance.”

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One Comment

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