U.S. TIPS and Canadian RRBs good investment bet

    TORONTO, Nov. 14 /CNW/ - CIBC (CM: TSX; NYSE) - Rising global energy and
food prices are fuelling headline U.S. inflation that could hit four per cent
by next fall, according to a new report from CIBC World Markets.
    The report finds that the U.S. Federal Reserve Board, which focuses on
core CPI (excluding energy and food prices), will ignore these headline
inflationary concerns in the near-term while it focuses on stimulating the
economy and keeping it from falling into a recession.
    "These secular inflation threats from food and energy will be set aside
by the Fed, which will be clearly focused on the cyclical threat to growth
from a collapsing housing sector," says Avery Shenfeld, Senior Economist with
CIBC World Markets and author of the report.
    Mr. Shenfeld notes that the Fed's focus on core CPI made sense in a world
in which gasoline or food prices went up and then came back down but that four
key longer-term trends are now driving energy and food inflation in the U.S.
    First, rapid energy demand in developing nations has stretched supply and
pushed crude oil prices to record levels. Second, energy price hikes combined
with a weakening greenback are increasing America's current account and trade
imbalance. Third, higher energy costs are being passed on to consumers and
businesses through a wide range of core items from airline tickets prices to
trucking costs to petrochemical costs for products like plastic. Finally, the
policy response to subsidize ethanol production has seen a rising share of
U.S. agriculture devoted to growing corn for ethanol production and this has
pushed up feed grain prices and in turn meat, dairy and egg prices.
    Mr. Shenfeld expects the Fed will cut rates in the short-term to kick-
start the economy and that improvement will begin in the latter half of next
year. This combined with continued pressures on energy and food prices will
see headline inflation continue to increase. "If, as we expect, this proves to
be no worse that a mid-cycle slowdown, the economy won't open up enough slack
to materially change the trajectory for inflation when better growth resumes
in the second half of 2008.
    "By fall of 2008, an economy that entered a slowdown with a headline
inflation rate above three per cent could be facing a headline rate taking aim
at four per cent. As a result, the Fed may be rushing to re-tighten (rates)
before year-end 2008."
    The report notes that this approach will see U.S. Treasuries, and by
extension, Canadian bonds, feel the heat of rising short rates, and that there
will be doubts about the ability of the renewed tightening to quell more
ingrained inflation pressures. On a relative basis, this will make inflation-
linked bonds a better play.
    "Unlike the Fed's focus on core CPI, the payoff on U.S. Treasury Inflated
Protected Securities (TIPS) is tied to headline CPI," adds Mr. Shenfeld.
"Right now, on a 10-year TIP, the implied inflation rate as measured by the
spread to nominal Treasuries, is roughly two and a half per cent. TIPS will
outperform Treasuries to the extent that inflation exceeds that implicit
projection over the life of the bond, or to the extent that the spread widens
as inflation expectations change."
    He also believes Canadian Real Return Bonds (RRBs) may benefit by late
2008, although this will be muted by the lagging impact of a stronger currency
in quelling import inflation. "Add in a GST cut, and we can't see Canadian CPI
topping two and a half per cent at any time in 2008. As well, even if it
watches only core inflation, by the Canadian definition, the Bank of Canada
will be taking meat, packaged foods and other such products into account.
    "Finally, the implied inflation rate in RRBs has not been as well
correlated with on-the ground headline inflation. Still, with inflation fears
in Canada likely to escalate as the U.S. economy rebounds later in 2008, RRBs
should still outperform a threatened nominal Government of Canada bond
market."
    The complete CIBC World Markets report is available at:
http://research.cibcwm.com/economic_public/download/occrept63.pdf

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