Bond markets are jittery and investors have reasons to be nervous.
The decision last week by the U.S. Federal Reserve Board to raise the discount rate - the interest it charges on the emergency loans it makes to banks - suggests the days of easy money marked by the Fed's zero-interest rate policy are numbered.
The Fed raised the discount rate by one-quarter of a percentage point, to 0.75 per cent.
While that signals another step in the return of financial markets to a more normal state, given the weak economy it will likely be some time before the Fed begins to raise its key federal funds rate. That is the rate that helps to hold short-term interest rates down in order to stimulate economic growth.
And it is that policy that has bond investors antsy. The worry is that the continuing low interest rate and loose monetary policies of the Fed will fuel inflation.
So far, inflation pressures as measured by the consumer price index have been relatively tame, if rising gasoline and food prices are excluded. The U.S. core consumer price index (excluding food and energy) on a year-over-year basis was 1.6 per cent in January, compared with 1.8 per cent in December.
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However, overall the annual inflation rate is 2.6 per cent, reflecting higher gasoline prices and the beginning of higher food prices resulting from the impact of the Florida freeze on fruit and vegetables, according to BMO Nesbitt Burns Inc.
Bond investors are being torn between the safety of holding U.S. Treasuries and the risk of seeing their savings eroded by inflation. Recent action in the bond markets illustrates the forces at work.
The short-term action has been dramatic.
The U.S. Treasury Inflation-Protected Securities bonds, or TIPs, are securities that provide a return tied to the CPI data, including food and energy. TIPs have experienced a sharp selloff during the past few weeks, after a year in which they outperformed conventional Treasuries by more than 10 per cent. The recent drop has lowered the out-performance to about 7.6 per cent.
"I have been aggressively selling TIPs during the past month, and have been selling since some time last year," said Mihir Worah, a managing director and head of the real return bond desk for Pacific Investment Management Co., or Pimco, the world's largest fixed-income manager.
A year ago, Pimco saw TIPs as an excellent investment opportunity because they were priced as if there would be deflation for six or seven years. "Let's hope this call is right, too," Mr. Worah said.
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The price of TIPs now implies an inflation rate of 2.3 per cent over the next 10 years, he said. Mr. Worah has reduced his TIPs holdings to 81 per cent of the portfolio (the minimum holding allowed under the fund charter) because there is a chance inflation will be less than expected over the next few months, as a result of the strength in the U.S. dollar and the slow economy.
Pimco is also avoiding U.S. bonds given the debt problems. "TIPs, after all, are U.S. government debt," Mr. Worah noted.
Meanwhile, the U.S. Treasury markets continue to suggest the risks are high. The spread or difference between two-year and 10-year Treasuries reached a record high last week of about 293 basis points before easing to 286 points. (A basis point is 1/100th of a percentage point.)
The wide spread reflects not only the long-term inflation outlook, but also extraordinarily low short-term interest rates, global credit concerns and expected real returns on the bonds, said Mark Chandler, a fixed-income strategist with RBC Dominion Securities Inc.
Despite the aggressive stimulative monetary policies, the excess cash being held by the banks has not contributed to inflation because bank lending has been restrained, Mr. Chandler said.
In Canada, the inflation-linked real return government bond prices have been dropping sharply this year as investors worry they are paying too much for the inflation protection at a time when economic growth may be slowing, according to Bloomberg News.