By Richard Leong
NEW YORK (Reuters) - Market indicators are flashing signs that investors see inflation - after it was almost non-existent since the credit crisis - on the rise, despite skepticism from the Fed and the relatively slow pace of U.S. economic growth.
Federal Reserve Chair Janet Yellen and other top policymakers are not convinced that inflation is heating up enough to warrant higher rates. But developments in inflation-linked bonds and the dollar show an inflation trade is back in vogue, especially as oil and other commodities have rebounded from multi-year lows.
Investors see the turnaround in commodities, as well as a dovish Fed, as a catalyst for stronger performance in inflation-linked assets, including Treasury Inflation Protected Securities. More money is now invested in fixed-income funds focused on inflation protection than in nearly three years.
"It's not a head-fake. It's a legitimate turn for the market," said Brian Jacobsen, chief portfolio strategist at Wells Fargo (NYSE:WFC) Fund Management in Menomonee Falls, Wisconsin.
The bond market in particular is signaling the upward shift in inflation sentiment, which had been battered five weeks ago with domestic oil prices tumbling to 12-year lows.
The yield premium on regular U.S. Treasuries over TIPS, known as inflation breakeven rates, has risen from the weakest levels since early 2009 on signs that domestic core inflation is accelerating.
"We could see reflation and that would bring us back to normal," Jacobsen said.
On Friday, the five-year TIPS breakeven rate rose to 1.54 percent, its highest since July, before retreating to 1.51 percent in late trade. The 10-year breakeven rate reached 1.64 percent, which was its highest since November, before fading a bit to 1.62 percent.
WARMING UP TO TIPS
The recovery of TIPS breakeven rates since they bottomed on Feb. 11 has sparked a fresh wave of cash into the bonds.
Assets of TIPS-focused funds, including exchange-traded ones, grew to $47.55 billion in the week ended March 16, the most since June 2013, according to Lipper, a unit of Thomson Reuters.
"Structural investors are coming back to the asset class. Some of them haven't been in them for years," said Michael Pond, head of global inflation-linked research at Barclays (LON:BARC) in New York.
Since mid-February, TIPS have posted a solid 1.13 percent gain, better than the 1.19 percent loss on regular Treasuries, according to indexes compiled by Barclays. But they lagged the more impressive 8.57 percent return on junk bonds and 12.18 percent on the Standard & Poor's 500 index (SPXT).
TIPS' gains have been partly stoked by the resurgence in oil and industrial metal prices during this five-week streak.
U.S. oil futures (CLc1) briefly broke above $41 a barrel on Friday to their strongest levels since early December. Copper has risen 14 percent since Feb. 11, while iron ore has jumped 20 percent.
The dollar index (DXY), meanwhile, has lost 0.56 percent since Feb. 11, and analysts at Bank of America-Merrill Lynch noted Friday that rising inflation tends to worsen performance in a currency, so they anticipate more losses in the greenback.
CAUTIOUS FED
While markets are waving flags about possible acceleration in inflation, the Federal Reserve sees downside risks from overseas, with lingering concerns about Chinese growth and further policy easing in Europe and Japan.
To be sure, a renewed drop in oil prices if major producers cannot arrive at a deal to freeze output, a sustained rebound in the dollar and/or signs of further global weakness could wipe out gains from the inflation strategy.
Fed officials on average halved the number of rate hikes they see this year to two from four at their policy meeting this week, and Yellen said Wednesday at her press conference she was not convinced U.S. core inflation has picked up.
U.S. core consumer inflation, excluding volatile energy and food components, is rising at a year-over-year rate of 2.3 percent, the highest since May 2012.
"Despite stronger data, the FOMC continues to question whether core inflation is really picking up," BofA/Merrill analysts wrote on Friday.
"The bottom-line of all of this, in our view, is ongoing upside risks to inflation breakevens as the markets recognize the Fed can create inflation after all."