Tumbling oil prices hurt U.S. inflation bonds

By Richard Leong

NEW YORK (Reuters) - Investors who bet on U.S. inflation bonds making a comeback in 2016 were caught wrong-footed in January as oil prices tumbled to 12-year lows and fears about China and emerging economies roiled global markets.

Owning Treasury Inflation Protected Securities was considered a low-risk bet in 2016 on the assumption that a supply-heavy world crude market would stabilize, lifting inflation expectations.

That has not happened. Instead, oil has fallen through $30 a barrel amid a persisting supply glut, dragging down a measure of inflation expectations to its lowest levels since the global credit crisis seven years ago.

"It's been painful," said Mark Lindbloom, portfolio manager at Western Asset Management Co. in Pasadena, California.

In January, TIPS did earn 1.48 percent in total return, but lagged behind the 2.13-percent gain on regular Treasuries.

Last month's small bounce is cold comfort for TIPS investors smarting from a 1.44 percent loss in the sector in 2015, when regular government debt eked out a 0.84 percent return, according to indexes compiled by Barclays.

Only junk bonds, which lost 4.47 percent, fared worse than TIPS last year among U.S. bonds.

MARKET 'IS STRAINING'

In addition, foreign central banks are said to be shedding holdings of TIPS and other U.S. government bonds, and digging into dollar reserves in an effort to stabilize their currencies against current market turbulence.

"The market right now just doesn't have the liquidity capacity to deal with these outflows," said Martin Hegarty, BlackRock's head of inflation-linked bond portfolios in New York. "No one is taking it on the other side, and the market is straining under the stress."

Despite the battering in inflation expectations, TIPS funds have been attracting modest inflows. They have pulled in over $250 million since the start of the year, according to Lipper, a unit of Thomson Reuters.

This move into TIPS is buttressed by data released on Friday showing that underlying domestic inflation and wage growth has remained stable despite the latest swoon in commodities prices.

"These are pretty good values (on TIPS). We are seeing some wage pressure," said Eric Stein, co-director of the global income group at Eaton Vance in Boston.

INFLATION OUTLOOK TAKES BEATING

The U.S. bond market's gauge on inflation expectations is measured by the difference in the yield premiums on regular Treasuries over TIPS, also known as inflation breakeven rates.

This measure, which the Federal Reserve monitors, has moved closely with oil prices, which have tumbled dramatically since mid-2014.

"No one wants to pay up for inflation protection. The Fed must be concerned," said James Camp, managing director at Eagle Asset Management in St. Petersburg, Florida.

U.S. policymakers tend to keep an eye on inflation expectations which can portend shifts in investor and consumer behavior.

In January, the five-year TIPS breakeven rate slid to five-month lows near 1 percent before rebounding, as oil picked up on reports of a possible output-reduction pact amongst oil producers.

The five-year by five-year breakeven rate, or investors' five-year inflation view in five years from now, had fallen to 1.48 percent 1-1/2 weeks ago, which was the lowest since early 2009. It recovered to 1.64 percent late last week.

Despite last week's rebound, breakeven rates have been stuck below the Fed's 2 percent inflation goal, making TIPS a tough sell. Last month's $15 billion 10-year TIPS auction fetched the weakest overall demand since July 2008.

"It's hard to see anyone who is looking for inflation protection for the next few years," said Aaron Kohli, interest rate strategist at BMO Capital Markets in New York.

(Editing by Bernadette Baum)

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