By Daniel Kruger
April 9, 2007 (Update1)
SourceApril 9 (Bloomberg) -- Rising oil prices, Mideast conflicts and a U.S. president perceived as ineffective contributed to the stagflation of the 1970s. Today, in the bond market, where Yogi Berra's immortal lines are increasingly invoked, ``it's deja vu all over again.''
Nowhere is that more evident than with Treasury inflation- protected securities. The difference in yields between 10-year TIPS and conventional notes has widened to about 2.5 percentage points, a seven-month high, and up from 1.43 percentage points in 2002. The gap suggests so-called real returns on the fixed-rate notes will be eroded by about $2.5 million annually on $100 million of securities.
``We have a measure of stagflation,'' said Paul Samuelson, who was the second recipient of the Nobel Prize in economics and helped popularize the term to describe slowing growth and accelerating inflation in the U.S. during the 1970s.
Investor confidence in the Federal Reserve's ability to restrain inflation, as measured by TIPS, peaked in October 1998, when the difference between the inflation-linked notes and 10- year Treasuries narrowed to a record low 0.647 percentage point.
The change in sentiment is reflected in investor returns. Inflation-linked notes due in 10 years and longer gained 1.80 percent this year, compared with almost 1 percent for Treasuries with similar maturities, according to Merrill Lynch & Co. data.
Politicians and Fed officials alike dread the bond market's response to changes in fiscal and monetary policy. Former President Bill Clinton found early in his administration that proposals were stymied by concern how bond investors would react, said James Carville, a Clinton consultant during the 1992 presidential campaign.
Hallmark of Policy
``Early in the Clinton days, the hallmark of policy was if you did this, how would it affect the bond market,'' said the 62- year-old Carville, from his office in Alexandria, Virginia. ``Every time I would talk to someone they would say `you can't do that, it will freak the bond market out.' I said `goddamn, whoever the bond market is, these bastards are powerful.'''
Samuelson, 91, said rising oil prices and the bursting of the ``housing bubble'' remind him of the 1970s, when former Fed Chairman Arthur Burns overheated the economy by holding interest rates low through the 1972 presidential election. An embargo by the Organization of Petroleum Exporting Countries quadrupled the price of oil, exacerbating the decline, he said.
Crude oil prices have almost doubled since April 2004 to $63.85 per barrel and the housing market is suffering its worst recession since 1991 as defaults on loans to people with poor or little credit histories mount.
`Real Cheap'
Inflation-indexed Treasuries ``look like real cheap insurance against the risk there could be higher inflation,'' said William Irving, who manages $23 billion in fixed income for Fidelity Investments in Merrimack, New Hampshire. Irving, whose TIPS holdings are on the higher end of his typical zero to 5 percent allocation, said he may buy more.
Inflation expectations as measured by TIPS yields have climbed since 1998 as stocks rose to records and the economy entered a seventh year of expansion. The difference in yields hasn't been less than 2 percentage points since October 2003 following two tax cuts, which spurred economic growth and led to a record $413 billion budget deficit in 2004.
The yield on the 4 5/8 percent note due February 2017 rose 10 basis points, or 0.10 percentage point, last week to 4.75 percent, according to Cantor Fitzgerald LP. Yields on the 2 3/8 percent inflation adjusted note due January 2017 rose 6 basis points to 2.26 percent. Yields were little changed at 3:50 p.m. in Singapore.
Most of the decline in prices occurred April 6 as traders pared bets the Fed will cut interest rates this year after the Labor Department reported the economy had added 180,000 jobs in March, more than economists had forecast.
Inflation, Growth
``The base case is growth moderates and there is some pressure from inflation,'' said Brian Brennan, who helps manage $10 billion in bonds at T. Rowe Price Group Inc. in Baltimore. ``We've increased our position in TIPS.''
The Commerce Department's price index for consumer spending on items excluding food and energy rose 0.3 percent in February. The price gauge rose 2.4 percent from a year earlier. It hasn't exceeded that level since April 1995. Fed Chairman Ben S. Bernanke says he's comfortable with inflation between 1 percent and 2 percent.
Economic growth has fallen below 3 percent during the three quarters ended in December. The Commerce Board's index of leading economic indicators declined 0.5 percent in February and 0.3 percent in January, its biggest two-month drop since November and December 2000.
New home sales fell 3.9 percent in February to an annualized rate of 848,000, while the supply of unsold homes rose to the highest level in 16 years, the Commerce Department said.
`Nowhere Near'
``Growth has slowed, inflation is higher than it was two years ago,'' said Jack Malvey, global fixed-income strategist in New York at Lehman Brothers Holdings Inc., who started analyzing utilities at Moody's Investors Service in 1978. However ``we're nowhere near'' rates in the late 1970s and early 1980s, he said.
Ten-year Treasury yields reached 13.65 percent in 1980 as the economy contracted 0.2 percent and consumer prices rose 12.4 percent.
Bernanke has acknowledged the Fed's dilemma. Policy makers removed their seven-month tilt toward higher rates on March 21, while also saying ``recent readings on core inflation have been somewhat elevated.'' Bernanke told Congress on March 28 that the central bank adjusted its wording to provide more flexibility because risks to economic growth ``have increased somewhat in recent weeks.''
The central bank has kept the target for overnight loans between banks at 5.25 percent since June, after 17 straight increases over two years.
`Wishful Thinkers'
``Wall Street has been full of wishful thinkers thinking if only Bernanke would lower interest rates,'' said Samuelson, a professor emeritus at the Massachusetts Institute of Technology, in an interview from Florida. ``Well he's not going to do it. He would lose his credibility if he did.''
Oil prices rose near their highest in six months last week as tensions escalated in the Mideast after Iran captured 15 British sailors and Marines in the Persian Gulf claiming they had entered Iranian waters. The naval crew was released April 5.
In 1979, Iranian militants occupied the U.S. embassy and held 52 hostages for 444 days, helping Ronald Reagan win election in 1980 as president as Jimmy Carter's popularity slumped. George W. Bush's job-approval rating dropped to an all-time low of 32 percent in February amid rising concerns for the war in Iraq, according to an Associated Press-Ipsos poll.
`Inflation is Persistent'
The Fed doesn't want to risk triggering a recession now by boosting its target, so ``you don't have pressure on real rates'' from the central bank, said Wan-Chong Kung, who helps oversee $36 billion in fixed income at FAF Advisors in Minneapolis, the asset-management arm of U.S. Bancorp. ``Inflation is persistent because their hands are tied, so they have to let inflation risk premiums rise.''
FAF Advisors began increasing its holdings of TIPS in late 2006 when the gap was 2.25 percent, she said. ``Stagflation is a very nice environment for TIPS.''
To contact the reporter for this story: Daniel Kruger in New York at
dkruger1@bloomberg.netLast Updated: April 9, 2007 03:54 EDT