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Ignoring the Fed on inflation seen a winning bet

Investors are often told not to fight the Fed, but in the US Treasuries market taking the opposite stance to the Fed has been a winning strategy in the past six months.

February 11, 2011 / 08:40 AM IST

Investors are often told not to fight the Fed, but in the US Treasuries market taking the opposite stance to the Fed has been a winning strategy in the past six months.

While Fed Chairman Ben Bernanke sees no inflation problem, bond investors who expect an economic recovery will lead to prices rising faster have been outperforming their peers.

Mutual funds investing primarily in short-duration Treasury Inflation-Protected Securities (TIPS) have outperformed those who have stuck to longer-term Treasuries, data from Thomson Reuters' Lipper service shows.

"I would argue that in a strange, even ironic way, that Ben Bernanke is doing a good job selling my fund for me these days," said Tom Luster, portfolio manager and director of investment grade fixed income at Eaton Vance in Boston.

"The more the Fed thinks that inflation is not a problem today the more likely it is that inflation becomes a problem in the future," he said.

The average maturity for TIPS is 8.70 years, however six-month returns for TIPS maturing in the 0-5 years range are up 1.198% while those maturing in 10 more more years are down 2.688%, according to Barclays Capital.

Returns for US Treasuries are down 2.186% over the same period.

The Eaton Vance short-term real return fund, while less than a year old, is among the top three performers in the last six months, returning 3.37% to investors.

But it is not simply that the fund has inflation-protected Treasuries in the portfolio but that the duration is very short, roughly two years. They argue against extending duration as this opens them up, along with everyone else, to interest rate risk from the Fed.

'It is all about expectations'

No one expects the Fed to raise rates from their current zero to 0.25% range anytime soon given the bigger focus on generating jobs. However, its quantitative easing programs have caused inflation expectations to rise.

"It is all about expectations. The Treasury market has been fading under the rapid rise of stocks. I think people are looking ahead and expecting inflation to be a greater concern, said Jeff Tjornehoj, interim head of Lipper Americas Research.

While benchmark 10-year US Treasuries have suffered an epic drubbing, causing yields to rise 125 basis points in the span of less than five months, the Standard & Poor's 500 index is up 17% in the same time.

The latest inflation data shows overall consumer prices rose 0.5% in December, however excluding food and energy costs, consumer prices rose just 0.1%.

Overall prices are up 1.5% in January from a year ago, while core consumer prices gained 0.8% in 2010, the slowest calendar year pace since the department started keeping records in 1958.

"Right now we are positioned cautiously against long-term Treasuries," said Kent Burns, portfolio manager at Franklin Templeton fixed income group.

But Burns added he is now less concerned about long-term rates rising as they have already surged considerably.

The firm's real return fund is up 0.92% year to date. It is the best performer in the group of 118 funds over a one year time frame with a 7.41% return.

Burns said the fund is not as exposed to TIPS but more importantly, similar to Eaton Vance's Luster, duration has been kept very short at just over one year.

Tips funds attracts USD 22 bn 

Treasury Inflation-Protected Securities are investments that protect against rising prices. Because they are indexed against inflation, TIPS holders will not see their principal lose value.

Moreover, the Fed and economists monitor the difference between TIPS and Treasury yields as a gauge of investors' inflation outlook.

This "breakeven" rate between 10-year TIPS and 10-year benchmark Treasury yields has risen more than 0.75 percentage points to 2.35% on Wednesday after the Fed signaled last August it was open to pursue another bout of large-scale bond purchase to help the economy.

The US central bank at that time was focused on averting a double-dip recession after the European debt crisis caused economic growth to sputter last spring.

So far this year, all Treasury debt has underperformed stocks and other riskier assets on worries over growing inflationary pressure due to faster global growth and surging commodity prices.

But TIPS have fared better than regular counterparts.

Lipper data shows investors have poured USD 22.35 billion into TIPS funds since the start of 2008. When factoring market prices, assets under management in US domiciled funds has increased to USD 39.9 billion, a 251% increase.

On the opposite end of the spectrum and in performance are funds such as the Wasatch-Hoisington US Treasury fund, which is down 7.36% y-t-d and off 12.39% in the last six months.

Lacy Hunt, the chief economist at Hoisington Management in Austin, Texas, says the Fed's quantitative easing policies are creating short-term gains but are really counter productive for the economy.

"In reality much of what the Federal Reserve has done has been to increase the income of the wealth divide rather than provide a net benefit," he said, citing the commodity price inflation that is costing the median US household an extra USD 1,300 in food and fuel.

"But they have raised short-term inflationary expectations which have been a detriment to the Treasury bond market and to our fund," he said.

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