Oil price-driven inflation fears hurt bonds

NEW YORK: US Treasuries yields rose on Wednesday for a second day with particular weakness in longer-dated securities as investors worried that soaring energy prices would lead to inflation.

Breakevens on some Treasury inflation-protected securities, reflecting inflation expectations, rose as unrest in the Middle East and North Africa sent oil prices to 2 1/2-year year peaks. Traders worried that the Federal Reserve would let inflation get a headstart as it tries to spur economic growth.

Inflation erodes the value of Treasuries over time so the 30-year bond was particularly hard hit, falling more than a point and a half, its yield rising to 4.60 percent from 4.50 percent late on Tuesday.

"If the Fed waits too long on inflation, the back end of the curve will sell off the most," said Ray Humphrey, senior vice president and senior portfolio manager of government, TIPS, and non-dollar sectors at Hartfort Investment Management, the latter with $159.6 billion in assets under management.

Benchmark 10-year notes fell 20/32, their yields rising to 3.56 percent from 3.48 percent on Tuesday.

From a policy perspective, rising long-term rates are more problematical for the economy than higher short-term rates because mortgage and corporate finance rates are tied to long-term rates, Humphrey observed.

"The market's over-arching concern is on unwanted inflation," said William O'Donnell, head of US Treasury strategy at RBS Securities in Stamford, Connecticut.

Minutes of last month's Federal Open Market Committee meeting noted the surge in oil and food prices, but showed most members of the policy group thought inflation risks from the commodity spike would be temporary.

Still, the economy and views on monetary policy have shifted from where they were a year ago, Humphrey said.

Inflation is still very low, but it's "more normalized and closer to the Fed's target," he said. An important goal of the Fed's stimulative monetary policy was to avert deflation.

The economy grew in the first quarter of 2011, as it did in the first quarter of the previous year.

"But this year's recovery is much different from the one that seemed to be occurring last year at this time and which turned out to be a bit of a 'headfake,'" Humphrey said. "This one is a little more balanced."

Consequently, some members of the US central bank's policy-making committee have begun to sound more hawkish, opining that the time has come for the Fed to gradually lift its foot from the monetary accelerator.

"Last year (Kansas City Fed President Thomas) Hoenig was the only hawk," Humphrey said, referring to the Fed official's strict inflation views.

"The number of hawks has increased and though the doves have the voting majority, the Fed is clearly split," he said.

Meanwhile, financial markets have an eye on the European Central Bank's meeting on Thursday, when the ECB is expected to raise interest rates, even as Portugal appears ready to request financial aid from the European Union.

"Everyone's focused on the ECB on Thursday," with few other major data releases, said Richard Bryant, head of Treasury trading at MF Global Securities in New York.

In late trade, two-year notes were down 2/32, their yields rising to 0.850 percent from 0.83 percent on Tuesday, while five-year notes fell 9/32, their yields rising to 2.32 percent from 2.27 percent late Tuesday.

A squeeze on short-term rate collateral eased with repo borrowing rates and fed fund rates both rising off their lows.