Looking past rate hike, some fund managers bet on rising inflation

By Dion Rabouin and David Randall

NEW YORK (Reuters) - As Wall Street readies for the first Federal Reserve interest rate increase in nearly a decade, some mutual fund managers and strategists are aiming at a trade that many see as a lonely bet - higher inflation.

Most measures of inflation remain subdued. The market has generally accepted that the Fed is going to start raising rates this month because the job market has improved, and less so because of inflation. The Fed expects inflation to rise to its 2 percent target, although in the last few years it has consistently fell short.

Because of that, market expectations for inflation have been falling, not rising, as many expected by now. The 10-year break-even inflation rate, as measured by Treasury Inflation Protected securities (TIPS), is currently at 1.61 percent. Six months ago, it was at 1.87 percent.

"The market is too benign in terms of pricing inflation right now," said Erin Browne, portfolio manager at Point72 Asset Management, formerly known as SAC Capital. She is buying break-evens, a trade in which an investor buys TIPs and sells regular Treasuries in hopes that the inflation-linked bonds outperform the fixed-rate variety.

Other areas of the market that would be expected to do well include high-yield bonds and energy. Those sectors, along with bank loans, industrials and Latam equities, are all bets that Bank of America-Merrill Lynch terms "inflation plays" and have recorded notable outflows throughout 2015.

"It's not that inflation is going to scream to the upside, but it's going to be higher," said Browne, noting this qualifies as a potentially underpriced "tail risk" in the market.

With the unemployment rate at 5 percent, wages have started to pick up, with notable mentions of job scarcity across numerous industries in the Fed's most recent Beige Book.

"While we're not inflation bulls, we're quite bullish relative to what the market is pricing in," said Michael Pond, head of global inflation markets strategy at Barclays.

Along with higher wages - a typical driver of inflation - medical costs could play a larger role in pushing prices higher in the coming year, bond strategists say. Healthcare costs account for 24 percent of the core personal consumption expenditures price index, the Fed's preferred measure of inflation, Barclays notes. Medicare premiums are set to rise by 2.5 percent on average next year, while private plan premiums should rise by 2.8 percent, it estimates.

Pond expects inflation to run at 1.8 to 2 percent over each of the next two years, nearly double the 1 percent rate projected by the short-term bond market. He is bullish on short-end break-evens.

Overall, investors are modestly adding to their bets on inflation. TIPS-focused mutual funds and ETFs have seen inflows of $3.8 billion so far this year, compared with outflows of $2.6 billion over the same period last year, according to Lipper.

Even a small rise in inflation will likely create a "massive steepening" in the yields of 30-year Treasuries, said Ashwin Alankar, global head of asset allocation at Janus Capital Group, which had $192 billion under management as of the third quarter.

"As inflation starts becoming more evident in the economy, people will start exiting the crowded trade of holding the long end of the bond market, which is the most crowded trade today," he said.

Alankar has been moving more of his portfolio out of 30-year Treasuries and into the shorter end of the yield curve in anticipation that a rush of investors out of long-dated bonds will send yields on 30-year Treasuries closer to 4 percent from the current 2.98 percent. Such a move would be the largest jump in yields since the financial crisis.

Not every fund manager is bullish on inflation, of course. Carl Kaufman, co-portfolio manager of the $5.8 billion Osterweis Strategic Income fund, said that poor retail sales suggest the economy is not strong enough to boost inflation.

Yet Martin Hegarty, managing director of BlackRock's global inflation and bond portfolios, said a bottoming out of oil and other commodity prices will dispel concerns about deflation that have kept inflation expectations in check.

(Reporting by David Randall; Editing by Dan Grebler)

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