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Treasury market's inflation fears could lead to rise in interest rates

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(Bloomberg) — The Treasury market is starting to show renewed inflation expectations, giving the Federal Reserve more latitude to raise interest rates while most of the world’s other major central banks add to monetary stimulus.

The debt markets’ outlook for the pace of inflation during next five years has risen on more than half of the trading days this year. The yield on 10-year Treasury Inflation-Protected Securities, known as TIPS, auctioned yesterday at 0.315 percent, below the 0.346 percent forecast in a Bloomberg News survey, and reached as low as 0.11 percent Friday in New York, as investors sought protection against price increases.

While weak economic output in Europe, Japan and China has dimmed the global outlook, the recent pick-up in U.S. inflation expectations may give the Fed additional support to contract policy. Labor Department data released this month showed the U.S. unemployment rate fell in December to a six-year low of 5.6 percent.

“Some of the headwinds have started to ease up,” said Michael Pond, head of global inflation-linked research at Barclays Plc, one of 22 primary dealers required to bid at U.S. government-debt auctions.

Yellen’s view

Fed Chair Janet Yellen has signaled that momentum in the labor market will likely enable the central bank to increase near-zero policy interest rates in the middle of the year. The European Central Bank announced a sovereign debt buying program and central banks of Canada to Denmark cut rates.

The Treasury five-year break-even rate, which measures expectations for the average rise in consumer prices during the life of the debt, has risen to 1.25 percent. TIPS with five years to maturity reached a break-even rate of 1.04 percent on Jan. 14, the lowest since September 2009.

The Fed’s preferred inflation gauge, the personal consumption expenditures price index, has remained below the 2 percent target for almost three years and has been edging lower since May with the plunge in oil. The index showed prices rose 1.2 percent in the 12 months through November.

The U.S. sale of 10-year Treasury Inflation-Protected Securities drew a yield was 0.315 percent, the lowest since July, versus a forecast of 0.346 percent in a Bloomberg News survey of eight of the 22 primary dealers that are obligated to bid in U.S. debt sales.

Inflation-indexed notes pay interest at lower rates than nominal Treasuries on a principal amount that’s linked to the Labor Department’s consumer price index. Primary dealers took 25.9 percent of the notes, the least on record at auctions of the maturity.

The ECB pledged Thursday in Frankfurt to buy $1.2 trillion of bonds, including government debt, to head off deflation. And the Bank of Canada unexpectedly cut interest rates Jan. 21 to 0.75 percent from 1 percent.

Yellen told reporters last month not to expect the central bank to raise rates before the end of April.