Investors, Yellen Out of Sync on Inflation Views

By Min Zeng 

        In her testimony to Congress this week, Federal Reserve Chairwoman Janet Yellen said she was confident that inflation would pick up, signaling healthy U.S. growth.
        But many bond investors have their doubts.
        A closely watched measure of inflation expectations in the U.S. government-bond market sank to a seven-week low on Thursday even as Ms. Yellen noted tentative signs of growing wage pressures. Inflation should accelerate as the unemployment rate in the U.S. continues to fall, she said.
        Persistently tepid inflation--and downbeat inflation expectations--present the Fed with one of its biggest challenges as central-bank officials seek to determine the right time for the first increase in the short-term U.S. benchmark interest rate since 2006.
        The latest decline in inflation expectations coincides with renewed weakness in prices of commodities, ranging from oil to copper to iron ore, and a rising dollar. A stronger dollar makes imports cheaper, which exerts downward pressure on inflation.
        Ms. Yellen on Wednesday and Thursday said falling commodity prices and a stronger dollar were temporary. "My colleagues and I continue to expect that, as the effects of these transitory factors dissipate and as the labor market improves further, inflation will move gradually back toward our two percent objective over the medium term," she said.
        But sluggish global growth, in part, has made raw-materials prices vulnerable to a selloff. That shows little sign of changing, investors say, a situation that reinforces the belief that the Fed will go slow in tightening monetary policy. A slow pace of rate increases would reduce the risk of a sharp selloff in bonds and keep a lid on borrowing costs for consumers and businesses.
        The five-year break-even rate, or the yield spread between a five-year Treasury note and a five-year Treasury inflation-protected security, fell to 1.577 percentage points on Thursday, the lowest level since May 28. It suggests investors expect U.S. inflation to be running at 1.577% on an annualized basis on average within the next five years.
        That is down from 1.667 percentage points at the end of June and this year's peak of 1.863 percentage points on April 23.
        "The inflation indicators are moving in the wrong direction for the Fed, " said Jonathan Lewis, chief investment officer at Samson Capital Advisors LLC which has $7.1 billion assets under management. "Is Yellen defining transitory in days, weeks, months or years? 'Transitory' is getting longer and longer."
        Until recently, the inflation outlook was brightening. Crude-oil prices rallied in the second quarter after a seven-month selloff, and the dollar's rally had stalled. Worries in Europe about deflation--a potentially damaging cycle of falling consumer prices, spending and investment--ebbed.
        But oil prices have resumed their slide this month, in part because a crash in China's stock market sparked worries about growth and raw-materials demand in the world's second-largest economy.
        Meanwhile, Ms. Yellen's indications that the Fed is on track to raise interest rates this year has bolstered the dollar.
        "With the lack of inflation, Yellen will have a tough time raising rates in 2015," said Tom di Galoma, head of rates and credit trading in New York at ED & F Man Capital Markets.
        Mr. di Galoma said the Fed could delay a rate increase to 2016, a move that the International Monetary Fund has advocated.
        Ms. Yellen reiterated this week that an improving economy supports a rate increase this year, but she said the timing hinges on how the economy performs in the months ahead.
        Some data this week pointed to softness in the economy. U.S. retail sales unexpectedly fell by 0.3% last month. The National Federation of Independent Business's small-business optimism index unexpectedly fell to 94.1 in June from 98.3 in May. The White House earlier this week reduced its forecast for U.S. growth this year to 2%, from 3% predicted in February.
        Many investors see only a moderate chance that the Fed will pull the trigger in September. Fed-funds futures, used by investors and traders to place bets on central-bank policy, showed Thursday that investors and traders see only a 16% likelihood of a rate increase at the September 2015 meeting, according to data from the CME Group.
        "The Fed continues to threaten to tighten yet the market does not believe Yellen," said Richard Schlanger, money manager at Pioneer Investments in Boston which has more than $40 billion in assets under management. "So the Fed continues to move the goal posts. The market seems to be leading the Fed."
        Write to Min Zeng at min.zeng@wsj.com
        (END) Dow Jones Newswires

        July 16, 2015 17:14 ET (21:14 GMT)

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