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In Yellen We Trust Is Bond Mantra as Inflation Dismissed

As the Federal Reserve works to extricate itself from the bond market, its influence over debt investors is only increasing and boosting the chance of a soft landing for Treasuries.

While the Fed scales back the unprecedented stimulus that has inundated the world's largest economy with more than $3 trillion of cheap cash, the differences between short- and long-term yields of U.S. government bonds indicate that investors are confident Fed Chair Janet Yellen can keep inflation in check as growth rebounds without having to ratchet up interest rates.

The relative calm clashes with forecasters who say investors have grown too complacent over the direction of central bank policy with consumer prices climbing the most in more than a year and signs of labor-market strength. Bond bulls are instead focusing on the Fed's reduced estimate for how high rates ultimately need to rise and echoing the view of Pacific Investment Management Co.'s Chief Economist Paul McCulley, who said this month the taming of inflation starting in the 1980s means there's little risk in keeping borrowing costs low.

"The market is giving the Fed the benefit of the doubt that Yellen and crew have everything under control," Robert Tipp, the chief investment strategist at Prudential Financial Inc.'s fixed-income unit, which oversees about $335 billion, said in a June 19 telephone interview from Newark, New Jersey. "Inflation is not overheating even with job growth stable and the economy continuing to accelerate."

Debunked Thesis
In the past 13 months, the gap between yields of two- and five-year Treasuries has doubled to 1.22 percentage points, according to data compiled by Bloomberg. At the same time, the difference between those of five- and 30-year securities has narrowed to the least since 2009 as the long bond rallied.

Because yields on longer-dated debt usually rise more than shorter-term notes when investors see faster inflation spurring rate increases, the moves suggest a more sanguine outlook, according to Priya Misra, the New York-based head of U.S. rates strategy at Bank of America Corp., one of 22 primary dealers obligated to bid at U.S. debt auctions.

Taken together, the relationship now implies that while investors anticipate the Fed will eventually lift its benchmark rate after holding it close to zero for six years, they don't foresee the central bank's stimulus measures creating the kind of inflationary pressures that would force its hand, she said.

No Redux
"The bond vigilantes have all been quieted," Misra said by telephone on June 19. "The idea that just the act of printing money gets you inflation has been debunked."

The yield gap between two- and five-year notes was 1.23 percentage points at 11:45 a.m. in New York, while the gap between five- and 30-year rates was 1.73 percentage points.

That view also indicates there's little concern over a repeat of 1994, one of the worst years for bonds when Treasuries lost more than 4 percent in the first six months as the Fed began to double its benchmark rate to 6 percent, according to the Bank of America Merrill Lynch U.S. Treasury Index. In part because of the Fed's success as an inflation fighter, Treasuries generated returns in 2004, 2005 and 2006 even though the bank boosted rates to 5.25 percent from 1 percent.

This year, Treasuries have advanced 2.58 percent in the biggest year-to-date gain since 2011, even as the Fed began to pare back its $85 billion-a-month bond buying program.

Free Pass
Spurred by uneven U.S. economic and jobs growth, as well as tensions between Ukraine and Russia, the bond gains upended predictions by economists and strategists who foresaw a second year of losses as the five-year expansion reduced unemployment and spurred faster consumer-price increases.

Scott Minerd, who oversees $210 billion as the global chief investment officer at Guggenheim Partners LLC, says bond bulls are overlooking the risks of investing in Treasuries as demand for haven assets and lower rates around the world have held down yields and masked the strength of the U.S. economy.

"Geopolitical issues and technical factors have given the Fed a ‘Get Out of Jail Free' card this year, but that can't last forever," Minerd said in a June 20 telephone interview from Santa Monica, California. He estimates 10-year yields, which ended at 2.61 percent last week, need to reach at least 3 percent to provide an adequate level of compensation.

U.S. employers added more than 200,000 for four straight months, the first time that's happened since 2000, while consumer prices rose 2.1 percent in the year ended May, the most since October 2012, a government report showed last week.

Yield Forecasts
Economists, who are sticking by their calls that yields will rise this year and end at 3.05 percent, also predict the Fed will raise its benchmark rate more than fixed-income investors anticipate as growth accelerates and inflation picks up, according to a Bloomberg survey on June 12-16.

Fed policy makers said on June 18 that they expect their year-end rate will reach 1.13 percent in 2015 and 2.5 percent in 2016. Trading in the futures and swaps markets indicate the benchmark rate will remain below 2 percent through March 2017.

For Pimco's McCulley, who is credited with coining the term "shadow banking system" to describe financial networks outside of traditional banks, the lack of sustained inflation is a greater concern for the Fed because of how effective the central bank has been in quelling price increases after then-Chairman Paul Volcker raised rates to 20 percent in 1980.

Since 2009, consumer prices in the U.S. have increased less than 2 percent on average, versus 3 percent during the three prior periods of growth, data compiled by Bloomberg show.

‘Well Anchored'
The Fed's preferred gauge of inflation, the personal consumption expenditures deflator, has also failed to reach the bank's 2 percent target for 24 straight months.

Inflation "expectations have been ‘well-anchored,'" McCulley, who returned to Newport Beach, California-based Pimco for a third stint last month, wrote in his inaugural "Macro Perspectives" column for the world's largest bond fund manager.

That means investors should instead focus solely on how high rates will rise to determine the extra yield bonds need to offer, he said. The Fed is already scaling back its own interest-rate expectations after cutting its growth estimate for 2014 last week. The central bank now forecasts a long-run target rate of 3.75 percent, compared with 4 percent previously.

Average hourly earnings are also rising a full percentage point less than in the last expansion, meaning there's little pressure for the Fed to employ tighter monetary policies that will hurt bondholders, according Dan Heckman, a Kansas City, Missouri-based senior fixed-income strategist at U.S. Bank Wealth Management, which oversees $120 billion.

"Wage growth has been minimal to nonexistent," he said by telephone on June 18. Until that happens, "we won't see strong inflation and we won't see the Fed aggressively back off."