Inflation expectations in U.S. Treasury TIPS ease from 'overdone' level

By Karen Brettell and Karen Pierog

Jan 27 (Reuters) - Bond traders on Wednesday lowered their inflation bets as prospects for a massive stimulus package dimmed amid push back in the U.S. Congress, while increased federal borrowing could stymie another ramp up in the main market-based inflation gauge.

The 10-year Treasury Inflation-Protected Securities (TIPS) breakeven inflation rate slipped below 2% for the first time since late December and was last at 1.988%.

The rate spiked to 2.18%, its highest level since May 2018, following a strong TIPS auction on Jan. 21. That indicated the market expected inflation to average more than 2% a year for the next decade, above the current pace of inflation.

But many investors thought the probability of inflation rising much above the Federal Reserve's 2% average target anytime soon was lower than suggested by breakevens, given that economic growth could remain below potential for a while.

The run up in the rate was impressive and "a bit overdone," according to Zach Griffiths, interest rate strategist at Wells Fargo.

“I think you’ve had some exuberance when it comes to fiscal stimulus and what that may mean for economic growth and inflation prospects and more recently you’ve seen those expectations tempered a bit, and with that the prospects for inflation and growth have come down,” he said.

Democratic President Joe Biden's $1.9 trillion plan to aid the coronavirus-battered economy has raised concerns among Republicans in the U.S. Senate, which is evenly split between the two political parties. Democratic Vice President Kamala Harris has the authority to break a tie in the Senate.

Senate Democratic leader Chuck Schumer said on Tuesday an initial vote on passing coronavirus relief could take place next week through a process known as budget reconciliation, which only requires a simple majority vote.

Andrew Brenner, head of international fixed income at National Alliance, said he believes the size of the package will be reduced.

"So less stimulus (is) being built into projections, hence less anticipated inflation for now," he said.

Griffiths said Wells Fargo economists are eyeing a package in the $900 billion range, with more supply heading to the Treasury market.

"We think the bigger story is going to be rising yields as a result of more supply and in particular we think the TIPS auction slate will get a boost and that will put some upward pressure on real yields, at least matching what will happen with nominals, so that will result in further compression of breakevens,” he said. Real yields adjust for expected inflation and are currently trading at deeply negative levels, with the yield on 10-year TIPS at minus-1.04%. (By Karen Brettell in New York and Karen Pierog in Chicago; Editing by Alden Bentley and Chizu Nomiyama)