U.S. Treasuries post strong quarter but gains not so golden

By Richard Leong

NEW YORK (Reuters) - The U.S. Treasury debt market is on track to post its best quarter in 4-1/2 years, but looking under the hood, much of the gain stems from investors demanding more compensation for inflation as commodity prices recovered from multiyear lows.

The benchmark 10-year Treasury yield has fallen 0.48 of a percentage point since the end of 2015 to 1.798 percent as of late Tuesday.

Adjusting for investors' 10-year inflation expectations of 1.63 percent as measured by Treasury Inflation Protected Securities, the "real" yield on a 10-year government note is a measly 0.17 percent, the lowest level since May, according to Tradeweb.

Is it worth holding an investment that pays so little when compared with inflation?

"In terms of outright value, it's not that cheap," said David Keeble, global head of interest rates strategy at Credit Agricole Corporate and Investment Banking in New York.

Investors have pulled $2.9 billion from Treasury-focused funds over the past four weeks, reducing their assets to $105.2 billion, the lowest since early February, according to Lipper, a Thomson Reuters unit.

On the other hand, foreign demand for U.S. Treasuries has been brisk because of negative yields in Europe and Japan, analysts said.

Where have investors shifted their money to?

Much of the funds have gone into TIPS that offer inflation protection, as well as riskier but higher-yielding corporate and emerging market bonds.

These sectors had been battered from January into mid-February on signs of faltering Chinese growth and as oil prices tumbled to 12-year lows.

Anxious investors piled into safehaven Treasuries in this January to February period, resulting in a 3.7 percent gain. Since then, they have lost 0.7 percent, according to Barclays data.

BEST QUARTER SINCE 2011

Despite its recent deterioration, U.S. government debt has racked up a 3.01 percent return in the first three months of 2016, the strongest gain since 6.36 percent in the third quarter of 2011, according to an index compiled by Bank of America Merrill Lynch.

Treasuries fared better than the Standard & Poor's 500 index that has earned a 1.59 percent return.

However, they lagged TIPS' 4.04 percent return this quarter.

Treasuries handily beat corporate and emerging market debt in the earlier part of the first quarter, but they lagged in recent weeks as oil and industrial prices rebounded from their rout due to fears of a U.S. recession.

INFLATION HEDGE

While the U.S. economy is far from robust, domestic inflation seems to be finally firming towards the Federal Reserve's 2 percent annual goal.

The core rate on personal consumption expenditures, the Fed's preferred inflation gauge, grew at a 1.7 percent year-over-year pace in February after being stuck at a 1.3 percent rate for most of last year.

On Tuesday, Fed Chair Janet Yellen said the Fed should proceed "cautiously" on raising interest rates, which some traders perceived as the Fed's tolerance for inflation to rise above 2 percent.

"Some people are pricing inflation risk on the upside," Credit Agricole's Keeble said.

Richard Turnill, global chief investment strategist at BlackRock, the world's biggest asset manager, has recommended TIPS, gold and other assets that offer inflation protection this week.

Gold is on target for a 16 percent gain in the quarter, which would be its biggest quarterly increase in nearly 30 years.

(Reporting by Richard Leong; Editing by Andrew Hay)

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