Treasury Bears Capitulate as Fed Buying Meets Cliff Worry
Until last month, Donald Ellenberger, who manages $10 billion for Federated Investors Inc., shunned Treasuries as the U.S. economy improved and 10- year notes yielded less than inflation. Now, he can’t afford to stay out.
Ellenberger has plenty of company. Bond bears from Brown Brothers Harriman & Co. to T. Rowe Price Group Inc. are buying Treasuries though the 1.69 percent yield on 10-year notes is less than the rate of inflation and returns on the $10.9 trillion of marketable debt are the least in three years.
The combination of Federal Reserve efforts to stimulate the economy by buying bonds and the potential slowdown should politicians fail to avert the so-called fiscal cliff of tax increases and spending cuts has made Treasuries the debt that money managers have to own. Even investors who shun Treasuries don’t see 10-year note yields rising much above 2 percent.
“Treasuries offer little real value, but in the short term, it is just hard to be a bear,” Ellenberger, who is based in Pittsburgh, said in a Nov. 19 telephone interview. The company has moved from significantly “underweight” Treasuries compared with benchmark performance measures to adding the securities. “The fiscal cliff is a big deal, and the Fed is determined to keep rates low.”
Yields have fallen since the Nov. 6 election set up a budget showdown between President Barack Obama, who wants higher taxes on the wealthy and less spending, and Republican lawmakers who oppose raising tax rates on the rich. If they can’t agree, $607 billion in spending cuts and tax increases starting Jan. 1 will cause the world’s biggest economy to contract 0.5 percent next year, according to the Congressional Budget Office.
“Uncertainty” about the fiscal cliff, debt limits and the long-term challenges of balancing the U.S. budget are already “affecting private spending and investment decisions and may be contributing to an increased sense of caution in financial markets, with adverse effects on the economy,” Fed Chairman Ben S. Bernanke told the Economic Club of New York on Nov. 20.
Efforts to boost employment and spur the expansion with purchases of $40 billion in housing debt each month are being impeded by the budget impasse, Bernanke said.
Yields on 10-year Treasury notes fell six basis points, or 0.06 percentage point, since Nov. 6, to 1.69 percent as of Nov. 23, from the 2012 high of 2.4 percent on March 20. The yield rose 11 basis points last week, equaling the most since the five days ended Oct. 19. The price of the 1.625 percent security fell 1 point, or $10 per $1,000 face value, to 99 12/32, according to Bloomberg Bond Trader prices.
The yield fell three basis points to 1.66 percent as of 3:01 p.m. New York time.
Bonds have rallied even as the U.S. economy expanded at a faster-than-forecast 2 percent annual rate in the third quarter, concern has eased that the European debt crisis will spread and yields on 10-year notes are below the inflation rate.
The 10-year Treasury yield will rise to 2.1 percent by the end of September, economists said in a Bloomberg News survey from Nov. 9 to Nov. 14. The forecast is down from 2.5 percent in a poll conducted from July 6-10 and compares with the annual average rate of 6.49 percent during the past half century.
With the Fed’s policy measures, Treasury yields are “ignoring the progress that has been made on the economic front,” Jeffrey Schoenfeld, chief investment officer at Brown Brothers Harriman in New York, which manages $33 billion in assets, said in a telephone interview Nov. 16. The Fed will probably succeed at holding the 10-year yield below the growth rate of nominal gross domestic product, which it tends to track during conventional economic expansions, he said.
GDP in current dollars grew at an annualized rate of 4 percent in the period from July to September while the 10-year yield averaged 1.62 percent for the period, a difference of 2.38 percentage points. The gap reached a record 2.9 percentage points on May 31.
Schoenfeld said Brown Brothers is adding Treasuries after preferring investment-grade U.S corporate bonds, which have returned 9.9 percent in 2012, according to Bank of America Merrill Lynch index data. That compares with 2.3 percent returns for Treasuries, down from 9.8 percent last year and 5.9 percent in 2010.
Investors have bid a record $3.16 for each dollar of the $1.875 trillion in notes and bonds the U.S. government has sold at auction this year, Treasury data show, up from $3.04 in 2011. That demand has helped hold down interest expense on the debt to $359.8 billion, the smallest amount since 2005.
“The fundamental value of Treasuries should point to higher yields here, but the uncertainties of the fiscal cliff and the Fed on hold is keeping yields down,” Steven Huber, head of strategy at T. Rowe Price Group, which manages $58.3 billion in taxable fixed-income assets, said in a telephone interview Nov. 16. He began adding Treasuries this quarter after preferring corporate debt.
Bill Gross, who runs the world’s biggest bond fund, raised the proportion of U.S. government and Treasury debt at Pacific Investment Management Co.’s $281 billion Total Return Fund (PTTRX) to 24 percent of assets last month from 20 percent in September, according to a report on the company’s website.
After Bernanke forecast on Nov. 20 that U.S. economic growth is capped at 2 percent “at least for a time,” Gross said in Twitter post that the cap on the future pace was “probably lower” than the Fed chairman’s forecast.
Treasuries have lost some of their allure for mutual-fund investors. U.S. bond funds attracted $4 billion through October, compared with $17.3 billion for multi-sector funds, $48 billion for municipal debt and $126.2 billion for corporate securities, according to Morningstar Inc.
Speculators cut bullish bets this week after increasing them to the most in almost four months following the election, according to a survey by JPMorgan Chase & Co. The proportion of so-called net longs was at two percentage points in the week ending yesterday, down from 11 for the period ending Nov. 13.
“We look for investments that have a margin of safety, and it’s just gone away from Treasuries; there isn’t any,” Thomas Atteberry, who manages $5.1 billion of bonds at First Pacific Advisors Inc. in Los Angeles, said in a Nov. 19 telephone interview.
The bonds “don’t have what we consider a fundamental value,” said Atteberry, who last bought long-term government securities when George W. Bush was president. Since then the debt has returned 14.9 percent, according to Bank of America Merrill Lynch Indexes.
There has been no lack of demand with the Fed dissatisfied with job growth and inflation subdued. While the economy has added 4.4 million jobs since 2010 and the unemployment rate has declined to 7.9 percent in October from a high of 10 percent in October 2009, the numbers exceed the 6.1 percent average rate of the past 50 years.
The Fed injected cash into the economy by purchasing $2.3 trillion in bonds from 2008 to 2011 and said it will hold short- term interest rates near zero through mid-2015. Policy makers will probably buy about $85 billion in bonds per month starting in early 2013 and continuing into the second half, Fed Bank of San Francisco President John Williams said in a Nov. 14 speech.
“There is a lot of pressure for rates to rise, but with the Fed in action any rise will be pretty modest,” Scott Minerd, who oversees more than $125 billion as the chief investment officer of Guggenheim Partners LLC in Santa Monica, California, said in a telephone interview Nov. 5. The yield on the 10-year note would be as much as 200 basis points higher without central bank buying, said Minerd, who isn’t purchasing Treasuries.
Federated’s Ellenberger said bond market volatility may increase from a five-and-a-half-year low early next year when the Treasury projects it will reach the $16.4 trillion debt ceiling. The 10-year yield fell 0.42 percentage point to 2.74 percent in the month before Republicans in Congress and Obama reached an agreement the day before the Aug. 2, 2011 deadline.
“When you’re dealing with the economy you can analyze that in a rational framework, but it’s much more difficult when you are trying to analyze politicians,” Ellenberger said. “You can go back and look to last year’s debt-ceiling debate and see how acrimonious it was and can get.”
The Bank of America Merrill Lynch MOVE index, which measures volatility using options, reached 53.70 on Nov. 20, the lowest since it fell to a record 51.2 in May 2007.
Consumer prices rose at an annual 2.2 percent rate in October, compared with the 4.1 percent average since 1962. Real yields on the 10-year note, which take inflation into account, have fallen to negative 0.47 percent, after averaging 1.19 percent for the past decade.
The Fed’s preferred measure of inflation expectations, the five-year, five-year forward break-even rate, fell to 2.66 percent on Nov. 21, the most recent figure available in data compiled by Bloomberg, close to the lowest level in two months. The average during the past decade is 2.75 percent.
“I used to be much more bearish,” Yoshiyuki Suzuki, the head of fixed income in Tokyo at Fukoku Mutual Life Insurance Co., which has the equivalent of $70 billion in assets said in an interview Nov. 21. “U.S. Treasuries are the safe place to invest.”
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