Free-falling oil intensifies pain for U.S. inflation bonds

NEW YORK (Reuters) - Holders of U.S. inflation bonds are feeling the pain as tumbling oil prices intensify fears of global disinflation and a possible interest rate increase by the Federal Reserve next year.

Treasury Inflation-Protected Securities, commonly known as TIPS, become more popular when investors sense inflation is quickening. They performed well in the first half of the year, but due to global growth worries and the fall in oil, expectations for price increases have diminished, eroding the allure of these bonds.

As a result, TIPS have suffered a 1 percent loss in the second half of 2014, a U-turn from the 5.45 percent gain in the first half, Barclays data showed. Since September, investors have pulled $2.4 billion from TIPS-focused funds, according to Lipper, a unit of Thomson Reuters.

"I'm still cautious. I don't know how much lower energy prices will go," said Gemma Wright-Casparius, who manages Vanguard's $25.6 billion TIPS fund, the biggest of its kind .

Lower energy costs are often seen as a boon for consumers, but the current decline comes at a time when the Fed and other major central banks are wary that a further decline in oil prices might weigh on overall price growth, hurting the global economy.

TIPS investors are compensated as the headline U.S. consumer price index rises - so slower inflation makes TIPS less attractive.

Short-term inflation expectations as measured by the yield gap between five-year TIPS and regular five-year Treasuries fell to 1.16 percent on Friday, the lowest in nearly 4-1/2 years, Tradeweb and Reuters data showed.

Deutsche Bank's chief global strategist Binky Chadha said at the bank's outlook event on Wednesday that he recommended shorting five-year TIPS in anticipation of a further rise in yields as the Fed seems poised in 2015 to end the near-zero interest rate policy it adopted six years ago.

On Friday, the five-year TIPS yield rose to 0.34 percent, the highest since July 2010, ahead of a $16 billion sale of this TIPS maturity next Thursday .

Fed policy-makers meet next week and traders are waiting to see whether they will hint at a possible rate increase in 2015 even though inflation remains below their 2 percent goal. [FED/DAIRY]

To be sure, some analysts and fund managers said the TIPS sell-off is an overreaction to the drop in oil, whose prices hit a five-year low of $58 a barrel this week, down more than 45 percent from June.

"It makes the entire asset class beyond the very front end look exceptionally cheap," said Martin Hegarty, BlackRock's head of inflation-linked portfolios in New York and whose team manages $26 billion.

They, along with some Fed policymakers, reckoned a tightening domestic labor market would boost wage growth, which would offset the disinflationary effect of falling oil prices.

U.S. crude oil's drop is expected to cause the government's consumer price measure to fall in the coming months. Oil costs account for roughly 10 percent of the U.S. CPI in the form of home heating and gasoline, which TIPS values are referenced against.

(Graphics by Stephen Culp; Editing by Alan Crosby)