24 Aug 2009
Aug. 24 (Bloomberg) -- Bond investors that drove two-year Treasuries down on Aug. 21 by the most since early June after Federal Reserve Chairman Ben S. Bernanke said the economy is "beginning to emerge" from recession may find themselves wishing they had held onto the securities.While the comments sparked speculation that the central bank may soon raise borrowing costs as growth resumes, history shows the Fed is likely to keep its benchmark interest rate at a record low for a year or more. Policy makers didn't boost rates after the 2001 recession until 12 months into the recovery, while it was 17 months following the 1991 economic contraction.
"It's going to be very difficult for the Federal Reserve to raise rates simply because there's no inflation," said Michael Cheah, who manages $2 billion in bonds at SunAmerica Asset Management in Jersey City, New Jersey. "The two-year at a yield of 1 percent is an excellent yield," said Cheah, who has been buying the securities.
The yield on the benchmark two-year note rose almost 11 basis points at the end of last week, or 0.11 percentage point, to 1.1 percent, according to BGCantor Market Data. That was the most since it surged by the same amount on June 8. The note yielded 1.09 percent today as of 11:04 a.m. in Tokyo.
The slump came after the National Association of Realtors said sales of existing U.S. homes jumped 7.2 percent to a 5.24 million annual rate, the most since August 2007, and Bernanke said at a Fed-hosted central bankers' symposium in Jackson Hole, Wyoming, that "prospects for a return to growth in the near term appear good."
Speculative Positions
Trading positions show that the sell-off may be short-lived, even as the government prepares to sell $109 billion of Treasury notes this week, including $42 billion of two-year securities.
Speculative long positions on two-year notes, or bets prices will rise, outnumbered short positions by 158,041 contracts on the Chicago Board of Trade last week, the most since Dec. 7, 2007. That was just before the securities, which are more sensitive to changes in Fed policy than longer-term debt, posted their biggest quarterly gain since 2001, returning 3.26 percent, Merrill Lynch & Co. indexes show.
Zurich-based Credit Suisse Group AG, whose February recommendation to buy Treasuries due in two years earned about 0.85 percent versus the overall Treasury market's 0.7 percent loss, predicts yields will fall to 0.7 percent by the end of the year, according to data compiled by Bloomberg. If accurate that scenario would produce about a $1,000 return on a $10,000 investment.
‘Low-For-Long Stance'
Strategists at New York-based JPMorgan Chase & Co., the second-largest U.S. bank, said in an Aug. 21 report that they "recommend maintaining longs" on shorter-maturity U.S. debt. The firms are two of the 18 primary dealers of government securities that trade with the Fed.
"Macroeconomic fundamentals continue to point to a Fed that is likely to maintain a low-for-long stance," the JPMorgan strategists, led by Srini Ramaswamy, wrote in the report.
The inflation rate was unchanged in July after rising 0.7 percent in June, the Labor Department in Washington said on Aug. 14. Investors are betting consumer prices will fall 0.26 percent over the next 12 months and rise 0.28 percent over the next two years, compared with an average increase of 2.7 percent the past five years, prices of inflation-protected Treasuries, or TIPS, show.
Fed Vice Chairman Donald Kohn said the central bank's current policy to keep rates low for a long time is aimed at promoting price stability and not at spurring inflation.
‘No Inconsistency'
"The commitment to low rates is designed to keep inflation from falling and falling persistently below what we might want it to be for a long time," Kohn said on Aug. 22 during an audience-debate period at a the Jackson Hole symposium. "It's not designed to raise inflation expectations. There's no inconsistency there."
Kohn was responding to a presentation by Carl Walsh, a professor at the University of California at Santa Cruz, suggesting the Fed's stance is "potentially inconsistent" with its low-inflation goal and "requires careful balancing." The Fed cut its main rate to between zero and 0.25 percent in December and has pledged to leave it there for an "extended period."
In December 1992, the gap between two-year yields and the Fed's target rate jumped to 183 basis points. By the following March, it had narrowed to 74 points after traders realized they'd jumped the gun in anticipating higher borrowing costs. Policy makers didn't raise rates until February 1994. In September 2003, the spread hit 103 basis points before contracting to 44 in October, nine months before the Fed moved.
‘Remain Extremely Low'
Even after the Aug. 21 tumble, the odds of a Fed rate increase this year are just 13 percent, down from 24 percent a month ago, futures data on the Chicago Board of Trade show.
"The two-year yield will remain extremely low" as the Fed keeps rates unchanged "deep" into 2010, said Stephan Hirschbrich, who manages 1.3 billion euros ($1.86 billion) as head of international bonds at Union Investment in Frankfurt.
Most forecasters are convinced two-year yields are heading up. Even Hirschbrich, who's holding off on buying Treasuries until yields rise, foresees 1.25 percent within six months.
All but six of 47 economists and strategists in a Bloomberg survey see higher yields by January. The median forecast of 1.35 percent, up from April's 1.05 percent prediction, would increase the spread to the Fed target rate for overnight loans between banks to as much as 110 basis points, more than twice the average of 46 basis points over the past 20 years.
Square-Root Recovery
Bets for a quicker increase in yields are based on speculation that the economy's recovery will resemble a "V" -- a rapid slowdown followed by a robust rebound. Economists including former Fed Governor Laurence Meyer and Stephen Stanley at RBS Securities Inc. say there's a reservoir of consumer demand that will emerge and buoy the economy.
"It's amazing how many shapes have been discussed," said Christian Cooper, an interest-rate strategist at primary dealer RBC Capital Markets in New York, referring to recovery scenarios. "We've heard an ‘L,' a ‘V,' a ‘UU,' a ‘W.' I heard someone talk about a square-root sign" -- a quick rebound followed by a sustained plateau.
Critics of the "V" recovery include Mohamed El-Erian, the chief executive officer of Newport Beach, California-based Pacific Investment Management Co., manager of the world's biggest bond fund. They say there's been so much damage done to the economy during the crisis that growth will be restrained at 2 percent or less.
Taylor Rule
Bond bulls cite the Taylor Rule, an economics equation for predicting central bank policies based on policy-makers' tolerance for inflation and unemployment. Using median Bloomberg survey predictions in that calculation, the rule shows the Fed keeping its benchmark rate near zero and pumping money into the economy at least through June 2010.
"The end of the recession does not mean the end of the easing cycle," economists Christian Broda and Dean Maki at London-based Barclays Capital, another primary dealer, wrote in an Aug. 20 research report. "With a benign inflationary scenario and high amounts of slack in the economy, we expect the Fed not to raise overnight rates during 2010."
About 68.5 percent of the economy's plants and equipment was in use in July, down from the pre-crisis capacity utilization average of 79 for the five years ended in 2007. June's 68.1 percent was the lowest since at least 1967.
Following the 2001 recession, the Fed waited until the measure rose to 77.9 percent in May 2004 before raising its benchmark rate a month later from 1 percent, where it had been since the previous June and its then-record low.
‘Way in Front'
Ray Remy, head of fixed income in New York at primary dealer Daiwa Securities America Inc., is waiting for traders to misplay their hand again. He said he would buy once the yield, which touched a record 0.6 percent low on Dec. 17, hits 1.25 percent.
"The market will be way, way in front of the Fed," Remy said. "Most pullbacks are a buying opportunity, in my opinion," he said, referring to bond prices.
The two-year yield surged to 1.43 percent on June 8 and to 1.36 percent on Aug. 7 before falling back. Both jumps followed non-farm payrolls reports than were better than economists predicted.
The latter move came after the Labor Department said employers cut 247,000 jobs in July, the least since before the bankruptcy of Lehman Brothers Holdings Inc. last September pushed markets into the worst crisis since the Great Depression.
"The Fed is going nowhere fast," said Cooper at RBC. "Two-year rates are going to come lower, and we have considerable problems globally that are not going to be resolved quickly."
