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Bond Traders Diverge From Bearish Economists on Treasury Bonds

Monday, 09 Jan 2012 11:11 AM

Economists, emboldened by gains in everything from U.S. manufacturing to consumer confidence and jobs, are advising clients to get out of Treasurys. Traders aren’t so eager to give them up.

Benchmark 10-year yields will climb to 2.6 percent by Dec. 31 from 1.88 percent last year as growth accelerates, according to the median estimate of 63 economists and strategists surveyed by Bloomberg. Traders aren’t as optimistic, expecting an increase to 2.25 percent, based on forwards that use current trading levels to predict future rates.

The divergence shows traders see Europe’s debt crisis continuing to stoke demand for safety and containing yields even as the economy improves.

Predictions last year by both groups for a selloff proved wrong as Treasurys due 10 years or more returned 29 percent, the most since 1995, even as President Barack Obama increased publicly traded debt outstanding to a record $9.88 trillion and Standard & Poor’s stripped the U.S. of its AAA rating on Aug. 5.

“Analysts are making their forecasts based on a U.S. economy that is going into a recovery,” Hideo Shimomura, chief fund investor in Tokyo at Mitsubishi UFJ Asset Management Co., a unit of Japan’s biggest bank, said in a telephone interview Dec. 29. “For traders, they have to put their money somewhere during the European debt crisis. Treasurys are the safe haven.”

Losses Forecast

An increase in 10-year yields to 2.6 percent would result in a 3.1 percent loss for an investor who bought on Jan. 6, according to data compiled by Bloomberg. A yield of 2.25 would bring a 0.4 percent loss. Both would be near historic lows and less than the average yield of 4.93 percent over the past 20 years, according to data compiled by Bloomberg.

Bonds fell last week as the Institute for Supply Management’s factory index showed manufacturing expanded in December at the fastest pace in six months. Ten-year yields rose 8 basis points, or 0.08 percentage point, to 1.96 percent, Bloomberg Bond Trader prices show. The price of the 2 percent security maturing in November 2021 fell 23/32, or $7.19 per $1,000 face amount, to 100 11/32.

Valuation measures show no consensus on the direction of government debt. The so-called term premium model created by economists at the Federal Reserve reached negative 0.62 percent last week, not far from the record low of minus 0.63 percent in September, and compared with the average of positive 0.6 percent the past decade. A negative reading indicates investors are willing to accept yields below what’s considered fair value.

Relative Value

“Once you take the flight-to-quality element out, the growth outlook argues for Treasurys to be closer to 2.5 percent, and maybe as high as 3 percent,” Dominic Konstam, the global head of interest-rate research in New York at Deutsche Bank AG, said in a telephone interview on Jan. 3.

The firm, one of the 21 primary dealers of U.S. government securities that trade with the Fed, sees yields rising to 3 percent at year-end.

At the same time, 10-year yields exceed the federal funds rate by about 1.74 percentage points, compared with an average of 1.63 percentage points over the past 20 years, indicating the securities are fairly valued.

“The big question,” Konstam said, “is if, and how much, a European slowdown will affect the U.S.”

Beating Commodities, Stocks

Europe’s turmoil, which led to bailouts of Greece, Ireland and Portugal, as well as the downgrade of the U.S. by S&P, has made Treasurys must-have investments no matter what the price.

U.S. government securities returned on average 9.79 percent in 2011, including reinvested interest, Bank of America Merrill Lynch indexes show.

The Dollar Index tracking the U.S. currency against six peers rose 1.6 percent, while S&P’s GSCI Total Return Index of commodities fell 1.18 percent and the MSCI All Country World Index of shares lost 6.9 percent after dividends.

The 2011 rally surprised the market, with the median forecast of 3.75 percent among economists and strategists coming in 1.87 percentage points higher than where the yield ended — the biggest miss since 2008, when the U.S. was in its steepest recession since the Great Depression. Traders, at 3.71 percent, were off by 1.83 percentage points.

Christopher Low, the chief economist at FTN Financial in New York and the only one among 70 analysts who predicted the yield would fall to 2 percent by the end of last year, sees the rate at 2.10 percent at the close of 2012.

‘Lots of Uncertainty’

“There still hasn’t been a permanent solution for Europe,” Low said in a telephone interview on Jan 4. “There is still lots of uncertainty about the direction of fiscal policy, inflation isn’t a problem and we have a Federal Reserve that remains pretty active, which argues for lower rates.”

The rally also surprised Bill Gross, who runs the world’s biggest bond fund at Pacific Investment Management Co. He was a bond bear in the early months of 2011 before turning into a bull. He now recommends buying longer-term U.S. debt.

“The bulk of sovereign-bond holdings should be in the U.S.,” Gross wrote Jan. 4 on the Newport Beach, California, company’s website. Investors should favor Treasurys, he said, “as long as European credit implosion is possible.”

Gross’s $244 billion Total Return Fund gained 4.2 percent in 2011, underperforming 69 percent of its peers, according to data compiled by Bloomberg.

U.S. gross domestic product will grow 2.1 percent in 2012, compared with 1.8 percent in 2011 and 1.25 percent for all Group of 10 nations, Bloomberg surveys of economists show. The euro- region economy will contract 0.2 percent.

Jobs, Confidence

Three days after ISM’s Jan. 3 report on manufacturing, the Labor Department said the U.S. added 200,000 jobs in December as the unemployment rate fell to 8.5 percent, the lowest level since February 2009. Confidence among consumers rose to an eight-month high, the Conference Board said Dec. 27. A European measure of confidence in the economic outlook fell to the lowest in two years, the European Commission said Jan. 6.

“Traders look at Europe and see that the situation isn’t going to resolve itself quickly or neatly,” said Scott Graham, head of government bond trading in Chicago at Bank of Montreal’s BMO Capital Markets Corp., another primary dealer. “It’s hard for rates to sustain any kind of selloff. We still could see the end of the euro.”

Yields on 10-year bonds of Italy are higher than 7 percent, a level that preceded bailouts of Greece, Ireland and Portugal by the European Union and the International Monetary Fund. The euro fell last week to its weakest level against the dollar in 15 months, and traded at its lowest versus the yen since 2001.

S&P Warning

S&P placed the ratings of 15 euro nations, including AAA Germany and France, on review for possible downgrades on Dec. 5. Moody’s Investors Service said Dec. 12 it will review all 17 euro-zone countries after a summit Dec. 9 failed to produce “decisive policy measures” to end the debt turmoil.

Treasurys are also getting support from the Fed, which warned in December that “strains in global financial markets” are a risk to the U.S. economy.

Policy makers have pledged to keep the target rate for overnight loans between banks near zero at least through the mid-2013. The Fed is also replacing $400 billion of shorter- maturity Treasurys in its holdings with longer-term debt to contain borrowing costs, dubbed Operation Twist after a similar program in the 1960s.

Bonds rallied on the final trading day of last week after Federal Reserve Bank of New York President William Dudley said Jan. 6 that more monetary accommodation is appropriate.

Goldman Sachs Group Inc., another primary dealer, forecasts that 10-year yields will stay below 2.2 percent through the third quarter, before rising to 2.5 percent at year-end, according to a Bloomberg survey.

“We expect Fed officials to ease anew in the first half of 2012 via purchases of agency mortgage-backed securities, either on their own or combined with Treasurys,” Jan Hatzius, the firm’s New York-based chief economist wrote in a Dec. 30 report. “Fed officials would be loath to end their securities purchases.”

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2012-11-09
Monday, 09 Jan 2012 11:11 AM
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