U.S. 2-Year Treasuries May Fall as Fed Fights Housing `Froth'
U.S. 2-Year Treasuries May Fall as Fed Fights Housing `Froth'
July 11 (Bloomberg) -- U.S. two-year Treasuries may extend a year of losses as the Federal Reserve raises interest rates to fight what Chairman Alan Greenspan called ``froth'' in the housing market.
Greenspan dedicated half the 14 paragraphs of his testimony to Congress last month to housing, saying ``signs of froth'' and ``speculation'' in some areas neared ``unsustainable'' levels. The Fed on June 30 reiterated a plan to raise rates at a ``measured'' pace after increasing the federal funds target a ninth time by quarter percentage point, to 3.25 percent.
Two-year Treasuries will decline as policy makers lift rates until housing slows, said investors such as Michael Cheah of AIG SunAmerica Asset Management. Prices on two-year notes, more sensitive to changes in monetary policy than longer-maturity debt, are down 1.3 percent since the Fed started raising rates a year ago. Ten-year notes are up 5 percent.
``The Fed is trying to slow the housing bubble and there's a good chance that they'll overshoot'' by boosting rates too much, said Cheah, who manages $2 billion in bonds for AIG SunAmerica in Jersey City, New Jersey.
At the end of last week the yield on the benchmark two-year note was 3.77 percent, up from 3.07 percent at the start of the year and 2.82 percent in June 2004. Yields move inversely to bond prices. As the note's price fell, interest payments allowed an investor who bought $10 million of the securities on June 30, 2004, to earn $206,652, according to Bloomberg calculations.
The current two-year note, a 3 5/8 percent security maturing in June 2007, closed last week at 99 23/32 in New York, according to bond broker Cantor Fitzgerald LP.
Surging Prices
The median price of a home topped $200,000 for the first time in April, and is up 8.38 percent this year through May, compared with a gain of 9.14 percent for all of 2004 and 8.02 percent the year before. The figures are according to the National Association of Realtors, a Washington-based trade group.
By comparison, consumer prices rose at a 3.7 percent annual rate this year through May, compared with a 5 percent increase at the same time last year, according to the Commerce Department.
``It's gotten to the point where there's no paradigm to explain why a house costs what it does,'' said John Cerra, lead manager on a team that oversees $10.5 billion of fixed-income investments at TIAA-CREF Investment Management LLC in New York. The Fed's ``view is that they have to do something about it'' by continuing to raise short-term rates, he said.
Fed policy makers have more than tripled the target fed funds rate from 1 percent. A survey of the 22 primary dealers of U.S. government securities by Bloomberg in late June showed half expect the rate to reach 4 percent this year. The two-year note yields 52 basis points more then the fed funds target. The average the past 10 years is 40 basis points.
Fed `Bubbles'
``The two-year note is tied directly to the fed funds rate,'' said Gary Pollack, head of fixed-income trading at Deutsche Bank AG's investment-management unit in New York, which has about $12 billion in assets.
Fed policy makers probably learned from their experience of the stock market bubble in the late 1990s, when they were slow to raise borrowing costs, said TIAA-CREF's Cerra.
From April 1997 through June 1999, the Fed cut rates three times as the Nasdaq Composite Index more than doubled. The index then fell more than 50 percent from the peak in March 2000 over the next 12 months after the Fed began to raise rates -- almost three years following Greenspan's warning of ``irrational exuberance'' in the equity markets.
``The history of this Fed has been asset bubbles,'' Cerra said. ``They're going to try to manage the housing bubble more delicately than they did the stock market bubble.''
`Uncomfortable' Fed
Housing accounted for about one in every four of the 146,000 jobs created in June, according to a July 8 government report. Housing contributed 0.64 percentage point to the economy's first quarter growth rate of 3.8 percent.
Central bankers including Fed Governor Donald Kohn have said the same low rates that helped create economic growth also contributed to risks such as home-price bubbles that higher rates may correct. Atlanta Fed President Jack Guynn said May 25 he was ``uncomfortable'' with residential speculation in some markets.
The Fed's rate increases haven't slowed housing because of a drop in yields on long-maturity debt such as 10-year notes, which help determine terms on many fixed-rate mortgages.
Ten-year Treasury yields ended last week at 4.09 percent down from about 4.70 percent when the Fed started lifting rates. The rate on an average 30-year fixed mortgage was 5.62 percent in the latest week, down from 6.32 percent in June 2004.
Fed policy markets probably believe that continuing to push rates higher and talking about the ``froth'' in housing is the only way to cool the real estate market, said James Pagano, a debt investor at Merrill Lynch & Co.' asset management arm.
U.K. Australia Experience
``The actual raising of rates is the only tactic left at their disposal for pushing up long-term rates,'' said Pagano, part of a team that oversees $5.7 billion from Plainsboro, New Jersey.
Fed policy may end up backfiring by restraining the economy enough to keep inflation in check, said investors such as Pagano and AIG's Cheah. Tame inflation, which erodes the purchasing power of fixed-income payments, favors longer-maturity debt and may help to keep mortgage rates from rising too much.
Using the housing markets in Australia and U.K. as a guide shows that the Fed may not be quick to cut rates even if the economy shows signs of slowing, according to William Dudley, chief U.S. economist at Goldman Sachs Group Inc. in New York. The firm is one of the primary dealers.
``U.S. short-term rates are likely to stay high, for longer than expected,'' Dudley wrote in a July 6 report to clients. ``This should push up bond yields. If Australia and the U.K. have not yet cut short-term rates more than a year after (their) housing market peak, this suggests that a cut in U.S. short-term rates could be 18 months or more in the future.''
To contact the reporter on this story: John Dooley in New York at jdooley@bloomberg.net.
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