Bond market waits for Treasury to start monetizing debt

Treasury Yields Flattened as Fed Fights to Cut Mortgage Rates

By Liz Capo McCormick and Dakin Campbell
Bloomberg News
Tuesday, January 20, 2009

http://www.bloomberg.com/apps/news?pid=20601087&sid=adQkm5jF7vjc&refer=home

NEW YORK -- The Federal Reserve's inability to narrow the gap between consumer borrowing costs and government interest rates is driving investors to the longest-maturity Treasuries.

Central bank officials say they may buy Treasury debt, which helps determine rates on everything from mortgages to auto loans, to prevent borrowing costs from rising and delaying the economic recovery. Speculation that the purchases will start within days helped spark a rally last week in debt due in 10 years or more, reversing the worst start since before 1986.

Even though the Fed cut its target rate for overnight loans between banks to as little as zero in December, 15-year, fixed-rate mortgages averaged 4.76 percent last week, 2.44 percentage points above 10-year Treasury yields. The difference averaged 0.88 percentage point in 2003, when the Fed reduced rates to 1 percent.

"There is no point in fighting the Fed," said Piyush Goyal, an interest-rate derivatives strategist in New York at Barclays Capital Inc., one of the 17 primary dealers that trade directly with the central bank. "If for whatever possible reasons, 10-year and 30-year Treasury yields start rising, the Fed will come in and purchase these securities."

The bond market started 2009 by falling amid concern that the record amount of debt needed to finance a $1 trillion budget deficit would exceed investor demand and spark inflation. Fed Chairman Ben S. Bernanke helped spark a rally by reiterating Jan. 13 at the London School of Economics that he's considering buying long-term Treasuries to reduce borrowing rates as the recession deepens.

... 'Important Arrow'

In evaluating purchases, the Fed "will focus on their potential to improve conditions in private credit markets," he said in a speech.

Charles Plosser, the president of the Federal Reserve Bank of Philadelphia, said a day later in Newark, Delaware, that the central bank is ready to buy longer-term Treasuries. Lower yields could "spill over into private borrowing rates much more broadly," Federal Reserve Bank of San Francisco President Janet Yellen said Jan. 15.

"Fed officials use every chance they get to highlight Treasury purchases as an important arrow in their quiver," William O'Donnell, head of U.S. government bond strategy at primary dealer UBS Securities LLC in Stamford, Connecticut, said in a Jan. 16 research report. "It now appears as if the Fed may use Treasury purchases as a blunt tool to bring loan rates down further. This makes it more likely that Treasury purchases come sooner."

... Yield Forecast

The result for investors is that yields on 10-year notes may fall to within 0.5 percentage point of two-year notes, from 1.6 percentage points last week, O’Donnell said.

O'Donnell accurately forecast changes to the so-called yield curve that plots rates on Treasuries of varying maturities in an October 2007 research note titled "The Dawn of a Major Curve Steepening." He predicted that the gap between 2-year and 10-year notes would widen to 2.5 percentage points as the U.S. fell into recession. The curve, which was 0.54 percentage point at the time, steepened to 2.62 percentage points last November.

Now, an investor who sold $1 million of 2-year notes and purchased the same amount of 10-year notes would make about $28,000 if the 2-year yield rose to 1 percent, and the 10-year yield slid to 2 percent.

The yield on the benchmark 10-year note fell 7 basis points, or 0.07 percentage point, to 2.32 percent last week, according to BGCantor Market Data. The 3.75 percent security due November 2018 rose 19/32, or $5.94 per $1,000 face amount, to 112 1/2. Two-year notes underperformed, with yields dropping 3 basis points to 0.73 percent, approaching the record low of 0.60 percent set Dec. 17.

... Supply Concerns

The risk for investors is the amount of debt required to fund a $1 trillion budget deficit and the $825 billion stimulus plan proposed by Barack Obama, who will be sworn in as president today. Increased sales of Treasuries may still cause longer-maturity securities to underperform, pushing the yield curve wider, said Martin Mitchell, head of government bond trading at the Baltimore unit of brokerage firm Stifel Nicolaus & Co.

"The overriding factor now," Mitchell said, "is the potential for supply," which may push yields up on longer-term Treasuries such as those due in 10 or more years.

Economists at New York-based Goldman Sachs Group Inc. forecast Treasury borrowing will rise to a record $2 trillion this fiscal year ending Sept. 30, compared with $892 billion in notes and bonds sold during the last fiscal year.

... Credit Costs

Monetary and fiscal efforts will be successful in reflating the economy, with yields on 10-year notes climbing to as high as 2.75 percent in the first half of the year, Credit Suisse Group AG strategists Dominic Konstam and Carl Lantz wrote in a Jan. 16 report. Investors should be cautious about positioning for the selloff now, with several false starts likely before the curve steepening begins in earnest, they wrote.

Concern about higher borrowing costs rose in the first week of the year as government bonds fell, sparking losses of 1.1 percent through Jan. 8, according to New York-based Merrill Lynch & Co.'s Treasury Master Index, the worst start since before 1986.

While analysts expect 10-year yields to rise this year, they reduced their forecasts in the past month.

The median estimate of 58 economists and strategists surveyed by Bloomberg News is for 10-year yields to rise to 2.55 percent by June, compared with expectations for 3.1 percent in a December poll. The yield curve will be 1.6 percentage points at mid-year, down from 1.9 percentages in last month’s poll.

... Buying Mortgages

The problem for the Fed is that credit costs for households and businesses haven't followed yields on Treasury debt lower, even though policy makers reduced their target rate from 4.25 percent in January 2008.

Thirty-year, fixed-rate mortgages averaged 4.96 percent last week, according to McLean, Virginia-based mortgage finance company Freddie Mac, or 2.64 percentage points more than 10-year Treasuries. Before the credit markets began to seize up in the second half of 2007, the difference averaged about 1.78 percentage points since the start of the decade. Companies must pay an average of 9.25 percent to raise money in the bond market, up from 6.54 percent a year ago, Merrill Lynch index data show.

"The Fed wants to keep borrowing rates from going up," said Stuart Spodek, co-head of U.S. bonds in New York at BlackRock Advisors Inc., which manages $502 billion in debt. "They are trying to target the mortgage rate primarily, and ensuring that intermediate or longer Treasuries don't rise rapidly or sell off meaningfully is a way to do that."

The Fed already started buying securities to influence consumer rates, purchasing the first of $500 billion of mortgage-backed bonds.

... Fed Outlook

Anchoring the outlook for a flatter yield curve the next few months are expectations the Fed will keeps its target rate pinned near zero through much of 2010, Barclays' Goyal said. The curve flattened by 0.25 percentage point between June 2003 and June 2004, when the Fed held its target rate at 1 percent.

The central bank will keep its target within a range of zero to 0.25 percent though the fourth quarter, according to the median forecast of 61 economists surveyed by Bloomberg News.

"From a historical perspective, once the Fed gets to the end of an easing cycle, that is when the cyclical flattening of the yield curve begins," said Robert Tipp, chief strategist for fixed income in Newark, New Jersey, at Prudential Investment Management, which oversees more than $200 billion of bonds.

... 'Lost Decade'

Longer-term Treasuries also have room to rally because consumer price inflation, which erodes bonds' fixed payments, rose 0.1 percent in 2008, the smallest annual increase in half a century, the Labor Department in Washington said last week. Ten-year Treasuries yield 2.22 percentage points more than the inflation rate, compared with an average so-called real yield of 1.66 percentage points this decade.

Japanese government bonds during and after the "Lost Decade" of the 1990s provide an example of how the yield curve can flatten even as the government resorts to debt-financed public spending to spur growth, said Robert Blake, head of strategy for North America, in Boston at State Street Global Markets LLC. The firm has $15.3 trillion in assets under custody.

Deflation and a banking crisis in the 1990s led the Bank of Japan to adopt a zero-interest-rate policy and caused the government debt market to increase to 787.2 trillion yen ($8.48 trillion), or more than 1.5 times gross domestic product.

Even with the extra debt, the difference in yields between 2- and 10-year Japanese government bonds is 0.84 percentage points, compared with 2.55 percentage points in November 1995.

"The lesson is that when you go into a multi-year protracted shake-out with sluggish growth and limited inflationary pressures, government bond yields can stay extremely low for much, much longer than you think," Stephen Roach, chairman of Morgan Stanley Asia Ltd., said in an interview from Hong Kong.

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