December 15, 2016 / 9:22 PM / 7 months ago

UPDATE 1-U.S. inflation bulls brush off CPI, rate hike

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By Richard Leong

NEW YORK, Dec 15 (Reuters) - Investors who are bullish on U.S. inflation bonds are sticking to their bets in the wake of the Federal Reserve's latest interest rate increase and a report that showed domestic price growth cooled in November.

A surging dollar and a drop in oil prices on Thursday caused some traders to pare their holdings of Treasury Inflation-Protected Securities, which have been on a tear since Donald Trump's U.S. presidential win on Nov. 8.

"It is still an incredibly under-owned asset class," said Martin Hegarty, head of inflation-linked bond portfolios at BlackRock Inc in New York, the world's biggest asset manager.

TIPS, stocks and other risky assets have rallied on bets on faster U.S. growth and inflation under a Trump administration and a Republican-controlled Congress.

Rising oil prices following a deal among major oil producers to cut output have also stoked the appetite for TIPS.

From mid-October to end-November, assets in TIPS-focused funds grew by $3.47 billion to $56.42 billion, which was the highest since April 2013, according to Lipper, a Thomson Reuters unit.

TIPS funds, however, saw minor outflows last week, worth $63.5 million, Lipper data showed.

Since a dramatic bond market selloff following the U.S. election, TIPS have produced a negative return of 2.74 percent, compared with a negative return of 3.24 percent on regular Treasuries, indexes compiled by Barclays and Bloomberg showed.

On Thursday, inflation expectations weakened to their lowest levels in more than a week as the government's Consumer Price Index rose at a slower pace in November than October.

Fed policy-makers hinted a day earlier they expected a possible three rate increases in 2017, one more than some traders had expected. Perception of a faster pace of rate hikes also reduced inflation expectations.

The 10-year inflation breakeven rate, or the yield difference between 10-year TIPS and regular 10-year Treasuries, fell to 1.92 percent, which was the lowest since Dec. 5, Reuters and Tradeweb data showed.

The 10-year TIPS breakeven rate reached 2.03 percent, its highest since September 2014.

While negative news such as Thursday's CPI report would lead to profit-taking in TIPS, they are expected to fare better than regular Treasuries in the coming year, analysts said.

"Breakevens may become more volatile, but should continue to ascend," Wells Fargo Securities analysts wrote in a research note on Thursday. "We expect TIPS to outperform nominal Treasuries in 2017."

Reporting by Richard Leong; Editing by Chizu Nomiyama and Andrew Hay

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