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Treasuries Poised for Worst Year Since 1999 as Fed Raises Rates

Treasuries Poised for Worst Year Since 1999 as Fed Raises Rates

Oct. 24 (Bloomberg) -- The U.S. Treasury market is headed for its worst year since 1999 as Federal Reserve officials signal they will raise interest rates to keep near-record fuel prices from causing widespread inflation.

Treasuries are down 1.15 percent since June, trimming the year-to-date gain to 2 percent, including reinvested interest, according to Merrill Lynch & Co. data. The performance would be the worst since a 2.38 percent drop six years ago, when soaring stock prices and Fed rate increases cut demand for bonds.

After the biggest surge in consumer prices in a quarter century in September, some of Wall Street's most bullish bond forecasters are having second thoughts. Merrill Lynch Chief North American Economist David Rosenberg in New York is among those who this month revised their estimates, saying the Fed will continue to lift rates into next year.

Yields, which move inversely to bond prices, ``are headed higher largely as a result of the Fed increasing rates more than the market's priced in,'' said Jamie Jackson, who oversees trading of Treasuries at RiverSource Investments in Minneapolis, in an Oct. 21 interview. The firm manages $100 billion of bonds.

A slump pushed the benchmark 10-year note's yield up about half a percentage point in the past seven weeks to 4.53 percent on Oct. 14, putting it within 0.16 percentage point of its high for the year. Two-year yields, more sensitive to Fed policy, hit a four-year high of 4.29 percent this month.

Fed policy makers on Sept. 20 raised their target for overnight lending between banks by a quarter-percentage point for the 11th time since June 2004, bringing the rate to 3.75 percent. They meet twice more this year.

Global Performance

Returns this year trail only Japan among government bond markets, and compare with 3.50 percent in all of 2004 and 2.26 percent in 2003, according to Merrill Lynch index data. In the three years prior to 2003, returns averaged 10.6 percent.

The 10-year note's yield fell last week to 4.39 percent as a slump in stock prices boosted demand for fixed-income assets.

``The breakdown we're seeing in the longer end of the Treasury market has more to go,'' said Sam Paddison, who oversees $120 billion as head of customized fixed income for Evergreen Investment Management Co. in Philadelphia. ``Inflationary expectations aren't reflected in prices.''

Investors demand higher yields to compensate for the risk that inflation will erode the value of their interest payments.

Merrill's Rosenberg last week said 10-year Treasuries will yield 4.55 percent at year-end, compared with his prior forecast of 4.25 percent. A week earlier, he lifted his year-end target for the rate set by the Fed to 4.5 percent from 4 percent.

Rosenberg is among the more accurate predictors of interest rates. At the start of the year, the 10-year note yielded 4.20 percent and he forecast it would end June at 3.95 percent, compared with the 4.70 percent median estimate of 66 economists surveyed by Bloomberg. It was 3.92 percent at mid-year.

Joining In

Economists at Lehman Brothers Inc. in New York on Oct. 21 joined those at Merrill, Citigroup Global Markets Inc. and Banc of America Securities LLC that this month lifted their estimates for how many more times the Fed will raise rates. All of the firms are among the 22 primary dealers of U.S. government securities that trade with the central bank.

``With the party going full blast in the housing, credit and bond markets, the Fed is more determined than ever to drain the punch bowl,'' Ethan Harris, Lehman's chief U.S. economist, said in a report.

Harris raised his forecast for the Fed's benchmark rate in March to 4.75 percent from 4.5 percent. Ten-year note yields will rise to 4.8 percent next quarter, from a prior forecast of 4.7 percent, while two-year yields will climb to 4.6 percent, from 4.4 percent previously, he said.

Futures

Interest-rate futures in late August showed traders put the odds of a 4.25 percent year-end rate at less than 50 percent. The odds are now greater than 90 percent. They are fully pricing in a quarter-point increase to 4 percent on Nov. 1.

The last time the gap between 10-year yields and the Fed's target rate was this narrow was mid-2001, when the central bank was in the midst of cutting borrowing costs. If the difference holds up through year-end, the 10-year note would yield about 4.90 percent, giving an investor who bought at the end of last week a loss of about 3.07 percent, or $307,000 per $10 million invested, according to Bloomberg calculations.

Ten-year yields will be ``closer to 5 percent'' by February, said William Kohli, who manages $7 billion of bonds at Putnam Investments in Boston.

A surge in gasoline and heating oil prices to records after Hurricane Katrina struck the U.S. Gulf Coast on Aug. 29 caused prices paid by consumers to jump 1.2 percent in September, the most since March 1980, the Labor Department said Oct. 14.

Core inflation, which excludes food and energy, is still low by historical standards. Prices on that basis rose 2 percent in September from a year earlier. Prior to 1999, core inflation hadn't been that low since 1966.

Investor Confidence

Investor confidence in the Fed's ability to keep core inflation from accelerating may limit any increase in long-term debt yields, boosting returns for investors.

Ten-year yields are down from 4.76 percent when the Fed started lifting rates, and exceed core inflation by 2.4 percentage points, compared with an average of 2.9 percentage points over the past 10 years.

``The Fed does have credibility in terms of containing core inflation,'' Michael Materasso, who oversees $19 billion as head of fixed income at Fiduciary Trust Co. in New York, said on Oct. 20. Materasso said he pared his bet on higher yields when the 10- year yield reached 4.50 percent.

Fed policy makers are concerned rising fuel prices may prompt consumers to seek wage gains, sparking an inflationary spiral. A Fed survey prepared for its next meeting on interest rates, released last week, said several U.S. regions ``indicated that input cost increases are being passed through to retail prices.''

Crude oil for December delivery rose 61 cents, or 1 percent, to $60.63 a barrel on the New York Mercantile Exchange. Oil futures contracts have declined 14 percent since reaching a record $70.85 a barrel on Aug. 30.

``Inflation in an underlying sense is not high now, but there is a risk that it could go higher,'' Fed Governor Donald Kohn said on Oct. 19.

To contact the reporter on this story:
Elizabeth Stanton in New York at [e-mail]


LINK: http://www.bloomberg.com/apps/news?pid=10000087&sid=avu10rBK0Ms4&refer=top_world_news