Bonds Risk Summer Pain Trade as Inflation Hedging Surges

(Bloomberg) -- Here’s another clue that bond investors are at risk of a summer of pain.

The $1.4 trillion market for Treasury Inflation-Protected Securities shows expectations for consumer-price gains are moving closer to the Federal Reserve’s target as so-called breakeven rates trade at the highest since May. Another gauge of inflation expectations monitored by policy makers -- the five-year, five-year forward swap -- has surged in the past month too.

Inflation is a potential killer for popular bets that stagnant prices will keep the value of fixed-income intact. A severe enough sell-off in bonds poses a threat to U.S. stocks scaling new highs, Wall Street strategists are warning.

“The pain trade for the summer remains up in stocks and yields,” warned Michael Hartnett, chief investment strategist at Bank of America Corp. after the firm’s latest survey of money managers found a long Treasury position was the most-crowded trade last month.

Call it skewed logic, but a likely interest-rate cut this month from the Fed means long-term Treasuries are at risk of losses, even though bond markets usually cheer easier policy. That’s because what the central bank ultimately wants is faster inflation, which could sap the value of long-duration assets.

JPMorgan Chase & Co. strategists including Nikolaos Panigirtzoglou warned this month that crowded positions put investors at risk of an abrupt sell-off on par with the 2013 taper tantrum.

While demographics, globalization and technology mean consumer-price gains are unlikely, big bets against resurgent inflation suggest even a modest bump in yields could inflict steep losses on sovereign debt markets awash in near-record duration risk.

"It’s a risk to longer-end bonds," said James McCormick, global head of desk strategy at NatWest Markets. “The Fed clearly wants inflation higher and will set policy with that objective in mind. That should mean higher breakevens and a steeper yield curve. We are long TIPS at these levels.”

The market may have underestimated risks of price acceleration in the U.S. given its robust jobs market, and President Donald Trump’s tariffs policy is inherently inflationary, according to McCormick.

Elusive Inflation

Bond markets may have good reason to shrug off the inflation warnings. A decade of easy-money policies have failed to muster consumer price index strength, and any spike like the one in 2011 turned out to be fleeting. The average consumer price inflation in the past 10 year was 1.7%, which is below the Fed’s target of 2%.

Like McCormick, Eric Stein at Eaton Vance Group has been snapping up TIPS anticipating consumer price increases are set to quicken. The U.S. securities with principal and interest payments that increase along with official inflation measures are beating conventional peers in July for the first month since April.

The foreign-exchange market is also flashing inflation signals, with so-called growth currencies such as Canadian dollar, the New Zealand dollar and Brazilian real outperforming over the past month.

"The Fed is trying to get real yields lower and trying to get inflation expectations up and so it’s a pretty active part of the policy," said Stein in an interview. "I think TIPS are attractive."

--With assistance from Anooja Debnath and Wes Goodman.

To contact the reporter on this story: Anchalee Worrachate in London at aworrachate@bloomberg.net

To contact the editors responsible for this story: Samuel Potter at spotter33@bloomberg.net, Cecile Gutscher, Benjamin Purvis

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